The spotlight will shine on periphery woes

IRELAND is in trouble. The markets think it’s more likely to default on its debt than Argentina. It’s not alone though. Portugal is having a rough time too. Yesterday Portuguese and Irish 10-year bond yields hit 7.94 and 6.67 per cent respectively – record highs since the launch of the euro. The euro duly fell against both the dollar and the pound. Now that last week’s US quantitative easing (QE) announcement has dissipated the uncertainty surrounding the value of the dollar, attention has turned to the Eurozone’s troubles. This could potentially cause traders to flee both the dollar and the euro and seek sanctuary in the pound.

While sterling is likely to stumble ahead of today’s Bank of England’s quarterly Inflation Report, the British economy is generally looking good. Two weeks ago GDP data showed that the economy grew twice as fast as the market expected and the rating agency Standard & Poor’s said we no longer faced risk of a downgrade. So lined up against the dollar and the euro, sterling is still the least ugly of a fairly unattractive bunch. And the signs are beginning to show: RBS’s positioning report noted a positive change for sterling this week.

The forex market is behaving like a serial monogamist at the moment – focusing all its attention on just one issue at a time. Up until now, traders had been transfixed by the US QE situation. But now that the suspense has lifted it looks as if the spotlight has refocused on to the Eurozone’s troubles in the periphery, which previously traders had been all too happy to ignore. Traders have excused their negligence of this by pointing to strong German economic data. However this comfort could soon be snatched away, especially if Monday’s poorer-than-expected German industrial production figures for September are a sign of things to come. Economists had forecast a 0.4 per cent gain, but output fell 0.8 per cent from August.

Duncan Higgins of Caxton FX says this is already taking place: “We may be beginning to see the start of a shift in the market’s psychology… the euro has already dropped back below the $1.40 level and there is scope for the price to drop further if the economic woes of the Eurozone continue to hit the headlines.”

We can be sure it will hit the headlines. The European Central Bank (ECB) was forced to intervene in the government bond markets last week for the first time in almost a month. Financial markets are beginning to panic that the escalating Eurozone problems are moving into a nastier phase. Ankita Dudani of RBS says: “When the ECB is talking exit strategies and starting to unwind its unconventional monetary policy, the focus will shift away from the German economy to the state of the other 16 countries.”

This shifting spotlight will move money into a new market. With the US committed to QE, which will devalue the dollar, there are strong chances that the flight from the euro and dollar could wind up in sterling.