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Is it really smooth sailing?

This weeks update from currency expert Keith Spitalnick.

The UK economy has officially emerged from a deep recession, but is it really smooth sailing ahead now?  Mervyn King has indicated that he expects inflation to move above the 3% level, but that it will cool later on in the year.  Arguably the big question for this year is how quickly to withdraw the monetary and fiscal stimulus. Remove QE too early and we run the risk of a double dip recession however if QE is withdrawn too slowly then forecasts and assessments of our economic health become distorted as the economy relies on an artificial stimulus rather than institutional capital reserves.

The capital injected in the markets over the last 18 months was designed to free up lending, but even now the effects of more liquidity have not necessary permeated down to the high street.  Banks are now required to hold greater levels of capital, and move away from their preference for high risk high return trades.  These new regulatory requirements in the financial sector are reflected in the break down of our GDP figures and explain why Britain has only limped into the black this quarter.

Mervyn King is keeping a tight reign on the value of sterling, and the MPC’s increasingly ‘dovish’ perspective regarding inflation is the controlling factor for the pound over the next year.  Although the BoE realize that inflation is bad for our economy they would sooner keep the pound weak with interest rates low so as to nurture a stronger recovery.  The promise of obvious growth in the GDP figures released in January saw the pound rally to a 5 month high against the euro, and coupled with fears over the stability of the Portuguese, Irish, Greek and Spanish economies the pound has held form above 1.1350 for those tentative investors keen to get a quick return from the British market.

Some analysts have suggested that the only way the UK is to avoid a Greek or Spanish style economic crisis would be to increase income tax by 10%, VAT to 20% and the privatisation of the health service. Although there is always a threat of the double dip, it must be remembered that Greece and Spain had issues because of their ability to finance their debt. As the head of sovereign risk strategy at HSBC pointed out the cost of insuring a British government bond (gilt) means that there is ‘zero percent’ chance of Britain defaulting on her loans. Credit may be slow moving domestically, but internationally our debt is still an appealing investment.

Arguably the most important dates over the next two months will be 10th February and 15th March when we have the Treasury’s Inflation Report Hearings. During these hearings the BOE Governor and several MPC members testify on inflation and the economic outlook before Parliament’s Treasury Committee. If the comments are more ‘hawkish’ than expected we would expect a positive improvement in the value of sterling.

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