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Analyst Interview: Christopher Vecchio on the British Pound, Spain

Analyst Interview: Christopher Vecchio on the British Pound, Spain

Christopher Vecchio, CFA, Senior Strategist

The pound has shrugged off the GDP Q1 figs and is still doing well against the euro and USD. Why and will this continue?

The British Pound has been exceptionally strong the past few weeks, but the Sterling’s performance last week could have been stronger, perhaps, if the first quarter growth reading didn’t drag the United Kingdom back into a recession – in fact the ‘technical’ second leg of a double-dip recession. Still, with the recent shift by Bank of England policymakers towards a more hawkish bias and the Euro-zone sovereign debt crisis worsening once more, the Sterling has been well-supported by longer-term demand.

The main reason the British Pound is set to continue to appreciate has to do with the increasingly dovish monetary policies being implemented or threatened by many of the world’s major central banks simultaneously. Whereas the Bank of England has started to lean hawkish: Chairman Ben Bernanke of the Federal Reserve, despite boosted forecasts, talked down the economy, battering the US Dollar; the Bank of Japan has just unveiled another ¥10 trillion stimulus package; the Reserve Bank of Australia is widely expected to cut its key interest rate by 25.0-basis points on Tuesday; the Reserve Bank of New Zealand noted in their policy statement on Thursday that it could shift its monetary policy if the New Zealand Dollar remains elevated; and the European Central Bank is coming under increasing pressure to intervene in the secondary bond markets more to help support periphery debt, mainly that of Italy and Spain. In light of these strong fundamental trends – indeed, stronger than a weak GDP print– the British Pound is relatively bullish in the periods ahead from a fundamental basis.

The other strong currency at the moment is the CAD. Why is it one of the strongest in the G7?

Like the British Pound, the Canadian Dollar hasn’t been the beneficiary of strong economic data but rather an increasingly hawkish central bank. At their April policy meeting, Bank of Canada Governor Mark Carney said that higher borrowing costs “may become appropriate,” an indication that the BoC may move to raise rates at some point this year. While Canadian growth slowed a bit in February, this does not necessarily change the BoC’s outlook, though any hawkish bets should be trimmed after today. Nevertheless, the diverging monetary policies across the rest of the developed world (noted earlier when commenting on the British Pound) lean in favor of a stronger Canadian Dollar, which is relatively bullish in the periods ahead from a fundamental basis.

Spain – What’s the outlook for Iberia? What is the likely outcome of the vicious circle of the banks buying the government bonds and the government having to prop up the banks?

The key to what’s going on across Europe hasn’t necessarily been the financing the crisis but rather the social situation developing. It is important to note that while the European Central Bank and the International Monetary Fund have gone beyond their normal duties to try and support Europe’s financial institutions, it is entirely dependent on each nation’s politicians to agree on any and all bailout measures set forth to help periphery nations. As social services are cut, taxes are raised, and unemployment rates spike up across an austere Europe, it is likely that a highly destabilized populous rises to replace the same politicians that have implemented said austerity measures. Take a look at France: Francois Hollande, the Socialist challenger, is leading incumbent Nicolas Sarkozy in the French Presidential Election headed into the final vote this weekend purely on his position to renegotiate France’s position towards the European Union Fiscal Treaty. France has been one of Europe’s leaders during the crisis, and if the core is splitting – not due to rising borrowing costs or poor data but rather due to deteriorating living conditions – it is likely that further bailout measures are met with more resistance. Although current Spanish Prime Minister Mariano Rajoy only assumed office in December, if living conditions continue to deteriorate in Spain – the unemployment rate is already hovering near 23 percent – the government could be replaced with a candidate even further “right.” This would bring about more nationalist views in the government, which draw into question further efforts towards European solidarity. At the end of the day, unless economic data begins to show signs of improvement, Europe’s population is becoming more adverse to austerity and bailouts of the financial sector, which may soon come to an end if Europe’s “right” has their way.

There are striking parallels with Ireland. Are there lessons to be learned form the Irish?

The main lesson to take away from Ireland is how they handled their failing banks: very poorly. By nationalizing banks with excessive debt loads, the Irish government transferred all of that risk from the private sector to the public sector, ultimately pushing up Irish borrowing costs. On the nationalization of the banks alone, each Irish citizen was burdened with an additional €25,000. Here in lies the key question: would Ireland have needed a bailout if the government didn’t nationalize its failing banks? I would say no. The proper path for Spain to take in order to produce the best social outcome would be to follow the Icelandic model – let the banks fail, guarantee Spaniards’ deposits and savings, and let the natural forces of creative destruction weed out inefficiencies in the capital markets. This of course will not happen given the poor handling of the crisis, and it is likely that Spain follows the Irish path, unfortunately.

How serious is the drag effect of Spain’s problems on the euro?

The seriousness of Spain’s problems goes beyond the calamity experienced by Greece, Ireland, and Portugal combined. Consider this: according to the IMF, the nominal Spanish GDP for 2011 was $1,493.51 billion; the combined nominal GDPs of Greece, Ireland, and Portugal totaled $759.61 billion. Some quick math shows that Spain’s output is 1.96 times larger than Greece, Ireland, and Portugal combined – so we’re dealing with a very different set of circumstances in 2012 than we were with Greece in 2011. For conversation sake, the respective debt burdens of these countries offers a similar outlook – Spain is too big to fail.

While Spain may be too big to fail, European leaders don’t necessarily view it that way. Many times we’ve heard that the Euro-zone bailout fund isn’t large enough to save Spain, while some have flat out said that Spain will not need a bailout. A year ago, we were hearing the same thing about Greece – it’s clear that the Euro-zone’s policymakers have little knowledge or ability to correctly assess the crisis on their hands.

Spain, however, isn’t what market participants are worrying about – that crown goes to Italy. Given 2011 data available, Italy’s gross external debt of $2.494 trillion well-exceeds its 2011 nominal GDP of $1.826 trillion. If Spain succumbs to the debt crisis, contagion will easily spread to Italy, but at that point, it may be too late to keep the Euro-zone together in its current 17-member format.

--- Written by Christopher Vecchio, Currency Analyst for DailyFX for an interview with The Daily Telegraph

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