Sterling's rally against the Euro is expected to continue throughout the summer but at a more gradual pace despite the UK deficit being worse than previously announced, according to currency experts.
The next couple of weeks are likely to see some ups and downs after Prime Minister David Cameron warned of painful spending cuts ahead and Fitch Ratings said that Britain faces a 'formidable' fiscal challenge and needs to implement aggressive plans to reduce the record budget deficit.
The country's emergency budget on June 22 will have an impact on currency levels. 'The Pound's rally against the Euro could come to an abrupt halt should the spending cuts prove to be too much too soon. The government needs to find a fine balance: one that sufficiently appeases the market's desire to see the deficit cut, but falls short of strangling the fledgling recovery,' said Duncan Higgins, senior analyst at Caxton FX.
But the markets may become calmer. 'Through the summer, we expect to see Sterling's rally against the Euro continue, albeit at a more gradual pace than we have seen recently. Fears about the Euro zone banking crisis are failing to subside and investors will be inclined to continue selling the currency, particularly as most Euro zone officials seem apathetic, even content, with the Euro's slide,' he explained.
'Into the longer term Sterling's strength could be undermined as the UK's economic figures begin to reflect the spending cuts. April's Budget forecast for economic growth in 2010 and 2011 could well prove to be optimistic in light of new government policy. The Bank of England, in order to shield the economy against the cuts, will also be far less inclined to raise interest rates, seeing an increased pressure on sterling,' he added.
According to Fitch, interest payments on UK debt, currently rated AAA, may reach £70 billion in five years, from £31 billion in the past fiscal year. Another ratings agency Standard & Poor's also gives Britain the top credit rating but reserves a negative outlook on concern about the deficit. The shortfall, currently at 11.1% of gross domestic product, is the highest among the Group of Seven nations.
The fundamental weakness in the Euro may see the Pound continue to trade above 1.20 in the near term but the UK currency is likely to weaken further against the so called safe haven currencies like the US Dollar and Japanese Yen, according to Adam Solomon of Torfx.
Neil Mellor, a currency strategist at Bank of New York Mellon Corp, believes that the recent gains by the Pound will prove to be a 'temporary correction'. Analysts at Bank of Tokyo-Mitsubishi UFJ have advised investors to buy currencies considered to be the safest such as the Yen, US Dollar and the Swiss Franc because the global recovery will slow as governments focus on budget cuts.