Currency News Quantitative Easing

Currency News Update

UK MARKET – GBPEUR/GBPUSD

Ahead of the publication this morning of the minutes of this month’s Bank of England Monetary Policy committee meeting, the pound continues to regain the losses of the last week to edge up towards the 20 month highs seen earlier this month. If, however, the minutes show that the MPC’s Quantitative Easing (QE) program is not over, this could once again undermine the pound.

The pound recovered some of the losses of the last few days as the threat of the UK losing its AAA credit rating receded following the emergency budget.

The six week old government announced a series of measures including the imposition of a levy on banks and raised VAT in the biggest budget-deficit cuts in a generation, seeking to guard the top credit rating without stifling economic recovery.

Lowering forecasts for growth to 1.2% this year and 2.3% in 2011, Chancellor of the Exchequer George Osborne announced a freeze on public workers’ pay and child benefit along with a reduction in housing benefits. Capital gains taxes were raised and corporate-profit taxes cut.

“This is the unavoidable budget,” Osborne told Parliament, delivering the package six weeks after taking over. “Everyone will be asked to contribute.”

Tackling the largest fiscal shortfall in the Group of 20 nations may test the durability of the Conservative-Liberal Democrat coalition and the strength of union opposition. It also leaves the UK at odds with President Barack Obama’s stimulus drive on the eve of the G20 meeting in Toronto.

Osborne, 39, the youngest chancellor since 1886, is aiming to cancel a deficit that reached 11% of GDP in the last fiscal year. Fitch Ratings warned on June 8 the U.K. may lose its AAA rating if it fails to speed cuts. It has since commented that yesterday’s budget was “a good start”.

The pound and gilts rose as Osborne announced the plan would eliminate the structural deficit by 2015, with net debt peaking at 70% of GDP by 2014. He rejected suggestions the government needed to choose between growth and fiscal order as a “false choice.”

Overall, he said spending would be cut by 30 billion pounds a year, including 11 billion pounds from welfare, while the increase in value-added tax to 20% in January from 17.5% would yield 13 billion pounds a year by the end of the Parliament in 2015.

The levy on banks would tax their balance sheets starting next year, generating 2 billion pounds of revenue. The tax will be set at 0.04% in 2011, before increasing to 0.07%. The levy will apply to British banks as well as the subsidiaries and branches of overseas banks. Firms will only be liable for the levy when their relevant aggregate liabilities exceed 20 billion pounds, the Treasury said on its website.

Pledging to bolster investment and employment, the government put the corporate tax on a slide to fall 4% to 24% over four years and raised the threshold at which employers start paying national insurance.

To blunt the impact of the cuts and convince voters that ordinary Britons won’t suffer unduly, Osborne raised the ceiling at which the lowest rate of income tax is levied by 1,000 pounds to 7,475 pounds, exempting 880,000 low earners from payment. He also maintained spending on schools, hospital buildings and other infrastructure projects. The basic state pension will now be linked to earnings rather than prices, he said.

“Unemployment will peak at 8.1% this year before falling to 6.1% in 2015″ Osborne said.

In increasing the tax cap, Osborne adopted a policy of the Liberal Democrats, junior partner in a coalition with Osborne’s Conservatives. The increase in VAT may still lead some Liberal Democrats to rebel as unions call for an emergency meeting to develop a strategy to fight.

Policy makers say a Greek-style bondholder revolt is a bigger risk to the economy than a return to recession and that restoring order to the public balances will ultimately boost the economy. Bank of England Governor Mervyn King last week backed retrenchment and said “monetary policy could respond if the prospects for growth subsequently deteriorated”.

“Some have suggested that there is a choice between dealing with our debts and going for growth,” Osborne said. “The crisis in the euro-zone shows that unless we deal with our debts there will be no growth.”

The argument over how soon to withdraw stimulus as the global recovery gains momentum will play out on the world stage when G-20 leaders convene in Toronto on June 26-27.

Obama said in a June 16 letter to his counterparts that they must avoid the “mistakes of the past” when economic support was withdrawn prematurely, while German Chancellor Angela Merkel says “there is no alternative” to cutting deficits. Japanese Prime Minister Naoto Kan’s government today vowed to cap annual spending for the next three years and balance its books in a decade.

“The U.K. is a test case,” said Tim Adams, a former U.S. Treasury undersecretary and now managing director of the Lindsey Group, a Fairfax, Virginia-based investment consulting company. “If Osborne’s budget works that will have a profound impact on the debate in the U.S.”

Meanwhile, Fitch, the ratings agency said that although the risk of a euro zone break-up was low over the short to medium term, further episodes of “extreme market volatility” were likely to persist until the recovery and deficit reduction were secured in the region.

A report by Fitch said the crisis in the euro zone and investor concerns over the sustainability of the region had arisen because of the existence of the following:

• Economic imbalances.
• Scepticism over the ability of economies within the euro zone to adjust in the absence of monetary and exchange rate flexibility.
• Concerns about fiscal solvency given large fiscal deficits and weak economic growth prospects.
• Doubts over the political commitment to the euro zone in the aftermath of the hesitant and reluctant support given to Greece.

The report came as Juergen Stark, executive member of the ECB, said that markets and ratings agencies had behaved irresponsibly in response to the debt problems faced by Greece.

“What we have seen, how markets have reacted on Greece, on other countries, and in particular rating agencies, this was done in an irresponsible way, an irresponsible way in the case of Greece,” he said at a Centre for European Reform event in London.

“In the middle of negotiations [with the International Monetary Fund], rating agencies downgraded Greece. Markets have exaggerated the problems,” he added.

Mr. Stark argued that the euro zone’s monetary policy framework did not need to change because of the sovereign debt crisis.

“What we are witnessing now is not a crisis of the euro, what we are witnessing is a loss of public confidence by markets in the ability of governments to run sound and responsible fiscal policies,” he said.

“Where I do not see any need for an adjustment or change is the monetary policy framework we are in. We need to step up fiscal consolidation and implement structural reforms. Secondly, we have to strengthen the fiscal rules. And thirdly, the economic policy co-ordination has to be enhanced, and the surveillance as well.”

Mr. Stark said he did not believe that enthusiasm for euro membership was waning among the German public. Germany was perceived to be reluctant when it came to committing to a €500bn (£417bn) fund facility for troubled countries in the region.

“They, the Germans, have [seen] that the euro is a stable and credible currency, and they appreciate that the ECB has delivered over the past 10 years,” Mr. Stark said.

The Euro zone was further undermined when the rating’s agency Moody’s downgraded the credit rating of one of France’s top banks, BNP Paribas.