Euro and sterling – love to loathe

In the country of the blind, the one-eyed man is king. The dilemma for the currency market regarding the euro and sterling is deciding which one is the least unattractive. There are many similar deficiencies for both, including uncertain growth, fiscal pressures and political uncertainty. The simplest solution would be to assume a sideways trajectory for the cross, a stance reflected in consensus expectations, which show little change over the coming year. Yet we suspect this is an oversimplification. The overlaps may be prominent, but it is the disparities that will drive this cross, and many of those continue to point to further EUR/GBP downside in the coming quarters. Sterling, like its central bank governor, is King.

It is not hard to find reasons to be gloomy on either currency. Both are notably hindered by the growing FX market fixation on fiscal health. For the euro, this centres on the vulnerabilities in Greece and other high-yielding peripherals, while in the UK the deficit is already akin to that of Greece and forecast to decline rather more slowly. The attendant need for fiscal retrenchment is set to act as a considerable drag on growth in the coming years, adding to the trauma of the deleveraging process that has further to run in the private sector. Both the UK and eurozone economies are forecast to grow little more than 1% year-on-year in 2010 compared with an expected expansion of 3.2% in the US. On the basis of this consideration alone, it is not hard to see why these currencies are so disfavoured against the USD currently.

Another shared vulnerability is political risk, even if the nature of this risk is not identical. Greece is already suffering from considerable public unrest, which has raised market unease about the government's commitment to fiscal austerity. Spain too is drifting towards national industrial action while Portugal's austerity drive also continues. Furthermore, even outside the fiscally troubled parts of the eurozone, many governments are weak, hindering prospects for structural reforms. The UK government is a newly formed coalition of partners with few ideological overlaps. The honeymoon is faring well so far, but market doubts will linger over the durability of this marriage of necessity. Thus, economic and political risks make for a potentially unpleasant cocktail for both the euro and sterling.

However, we believe there are sufficient remaining disparities to ensure the current down-trend in EUR/GBP extends further. The big issue is, of course, the lasting and largely negative impact of the Greek crisis on the perception of the euro. The eventual policy response, though ultimately sizeable, has belied divisions within the eurozone over how to react to this crisis. It has also raised fresh questions over the longer-term viability of the euro project. The ‘one size fits all' ECB policy may face greater strains when some economies are contracting and others growing. The recent EU/IMF package has reduced the likelihood of the worst-case scenarios for Europe panning out, and the threat of sovereign implosion or euro break-up has substantially diminished. But the resultant market shift from euro attrition to euro apathy has simply changed the pace of decline. The probabilities attached to the ‘black swan' events may have fallen, but the central case remains sufficiently unattractive to prevent any euro relief.

Sterling may face fiscal strains, but there is no ‘project' at risk here, no black swan events for which the FX market needs to weave in a risk premium. Nor does sterling suffer the kind of credibility gap the authorities in Greece are trying to repair currently. The UK coalition government is less preferable than an outright majority, but there is a shared acknowledgement between the two parties that the deficit needs to be reined in. A new budget in June is likely to help assuage market nervousness regarding a fiscal policy impasse. It will not cheer up UK taxpayers, but rioting on the streets is a distant prospect.

"The overlaps may be prominent, but it is the disparities that will drive this cross and many of those continue to point to further EUR/GBP downside in the coming quarters. GBP, like its central bank Governor, is King."

In addition, Greece has reminded investors that the euro is not akin to German risk but to a portfolio of varying risks, which at the moment range down to Greek's junk status. Close to half of the euro's government debt stock is not rated AAA. By comparison, sterling represents a relatively clean prospect – a single economy, a single fiscal policy and a debt stock that is still viewed as AAA by the rating agencies if not by the markets. It is also worth remembering that, while both economies face difficult growth backdrops, the market expects the UK economy to outpace the eurozone's in both 2010 and 2011.

There is also the question of valuation or, for the beleaguered euro and sterling, how much of the bad news is already in the price? One measure in this regard is the fundamental equilibrium exchange rate, which currently shows the euro is 12% overvalued against sterling, even if both are justifiably undervalued against the dollar. On a simpler level, the euro is not yet especially stretched on the downside historically. Looking at the trade-weighted exchange rate, sterling is currently 18% below its 10-year average, whereas the euro is 45% higher.

Both currencies face a series of challenges in the years ahead But for a cross like EUR/GBP, it has to be about the relative extent of those challenges and risks that will determine its path. Superior UK growth, less pronounced political risk, ongoing though overstated questions over the euro project, and relative valuations all point to euro underperformance. The next two years are likely to see EUR/GBP push towards the 0.77–0.81 range that prevailed for much of 2008. Sterling is winning this battle of the battered.