The ECB’s asset purchase programme (QE) is buying Eurozone government bonds which drives up their price (increased demand) but the interest rate yield (which moves inversely to the price) is heading lower. The opposite dynamic is apparent in the US due to its robust economic recovery and rising interest rate expectations. The yield on a 10-yr German bund (government bond) is just 0.22% (the rate was 0.54% at the start of the year). This compares with 2.14% for the equivalent US government bond. The growing interest rate differential is a key driver behind the recent currency moves but not the only one. Political uncertainty surrounding Greece is still weighing on euro sentiment.
The robust US economic recovery has raised expectations that the Federal Reserve will start raising rates from mid-year. Next Wednesday (18th March) the Fed’s FOMC (the Fed equivalent of the BoE’s MPC) and Janet Yellen their Chairperson is likely to remove the key phrase that the Fed remains “patient”. Removal of this phrase (which is expected but not guaranteed) will signal a rate hike is probably coming in June. A rise in rates increases the yield differential between the dollar and the euro. If the patience language is retained, the dollar will give up some of its recent gains.
In recent years the talk in FX circles was of Euro / Sterling parity (it went as low as €1.02 on 30th December 2008). Now it has turned to Euro/Dollar parity. The Euro has moved from $1.25 to $1.0570 in the last 3 months. A sustained break below $1.05 which was the last low in March 2003 could see a further push towards Euro / Dollar parity. We expect a push to around $1.02 in the near-term. For reference, the record low in EUR/USD was $0.823 back in October 2000.
Of more significance to Northern Ireland has been the significant price action with Euro / Sterling. The currency pair has fallen by almost 2% over the last 24 hours and has touched 70.1p this morning. This means sterling touched €1.4256 this morning. These are levels last seen in November 2007.
Sterling’s strength has been more surprising than the dollar’s given that the Bank of England is not expected to raise rates until Q1 2016 (at least a couple of quarters after the Fed).
Furthermore, political risk is set to kick-in with sterling around the 7th May General Election with the uncertainty over what form the next UK government will take (likely to be a 3 party coalition). So far, financial markets have not turned their attention to this live risk. In the meantime, Eur/GBP is likely to push below 70p to around 69.5p (£= €1.44) in the near-term before rising to 71.5p (£ = €1.40) by the end of Q2. Thereafter, with clarity over the shape of the UK government and the Bank of England’s first rate rise drawing ever nearer (both sterling positive) we should start seeing Eur/GBP easing to 70.5p in Q3 and back to 69.5p by Q4 2015 / Q1 2016.
The Eur/GBP exchange rate is returning to rates that prevailed before the downturn kicked in. The Food & Drink sector benefited the most from the last 7-years of a price competitive exchange rate with local firms gaining market share from their counterparts in the RoI. Now the shoe is on the other foot with the RoI set to benefit at the expense of NI food producers.
The prevailing cross-border retail trade flows have been predominantly South to North over the last 7 years. 2015 / 2016 will see a reversal in this trend. Shopping centres already struggling with empty units, particularly those close to the border will suffer from a loss of custom which could lead to further vacant units.
In turn, this could threaten the financial viability of some centres. The local tourism and hospitality sector (including pubs and restaurants) face the double whammy of an uncompetitive exchange rate and an RoI VAT rate of 9% versus 20% in the UK. There is also the risk that after the UK General Election, which is expected to be followed by an “Emergency Budget Mark 2” in June, the current rate of VAT could be edged up to 21% for example.
Despite the fact that there is a lobby to cut VAT for the hospitality sector the next move in VAT is more likely to be up not down given the state of the UK public finances.
Given the anticipated Eur/GBP exchange rate in the months ahead, the agriculture sector is set to receive its lowest Single Farm Payment since 2007. The rate gets struck on the last trading day of September. The local construction sector has been relatively buoyant on the back of a buoyant GB market. As with the food & drink sector, RoI construction firms bidding for GB contracts and paying wages in euros will experience a cost advantage relative to their NI counterparts.
The main benefit of a strong exchange rate is low input cost inflation for businesses that import goods or purchase services from the Eurozone / RoI. Consumers seeking to holiday in the Eurozone will experience the most favourable exchange rate since the summer of 2007. Finally, 2015 is likely to represent the ‘sweet spot’ for those individuals fortunate enough to be considering the purchase of a holiday home in Donegal.
The exchange rate will ultimately lead to a strong Eurozone (and Republic of Ireland) economy, which will benefit Northern Ireland and the UK. But for now, we have to deal with the immediate challenges it brings.