Sterling on the March on Euro, US Anxiety
As we noted recently in this column, one is only as good as one’s last trade, and having dented my forecasting credentials in woeful fashion on UK gross domestic product (GDP) recently, it’s nice to bounce right back and see that our sterling predictions from three months ago, when sterling languished at 1.56 against the U.S. dollar and we targeted 1.62 by end of the second quarter and 1.65 by the fourth quarter, are right on track for early settlement!
The Economist even had an article on sterling strength this week, and as I am always happy to point out their successful early calls perhaps they will repay the compliment one day and quote this column?
Sterling broke through 1.62 last week, having struggled through most of March and April around the 1.57-1.58 level. We stick with our forecast and in fact advance it, sterling should be at 1.65 against thegreenback during the third quarter.
It has also risen against the euro and is hovering around a 12-month high of 1.24 .
Are there two views of the UK economy? The negative GDP, technical recession doom-mongering currently receiving extended airplay in the media, and the foreign exchange market’s belief that "UK plc" is worth marking up against everyone else?
Remember that we aren’t in a rising interest rates scenario, the common view sees Bank of England base interest rates as not moving for at least another 12 months if not 24…so why the upsurge?
Actually, it is possible for a country’s currency to be rising while its economy is still, if not stagnating then certainly not growing.
A whole host of causal factors drive foreign exchange rates, but the most significant one (after the good old-fashioned get-out clause of “supply and demand”) is relativity. One can be walking slowly and still win the race if everyone else is at a standstill or walking backwards. Relative to other currencies, sterling looks good right now, and for very valid reasons.
Exchange rates matter because the world deals in different currencies (and “one currency” should be up there with the utopian “world peace” aspirations of Miss World contestants), and in 2012 the sterling bloc is the No.1 beauty contestant.
The troubles of the euro zone certainly impact the UK economy, but not the sterling rate – sterling benefits precisely because it is outside the euro zone. It is untainted by fears of euro zone break-up or Spanish bank defaults.
Foreign central banks are increasing the weight of sterling in their reserve portfolios at the expense of euros, as reported in the same Economist article, which also quotes HSBC research stating that net flows of foreign direct investment into the UK has turned positive in 2012.
In other words, sterling benefits because it isn’t the dollar or the euro.
Poor US jobs numbers haven’t done the dollar any favors recently, and U.S. dollar interest rates are also not going anywhere for some time yet, so what is the alternative for foreign investors?
The size of the UK economy means that sterling assets are liquid and in supply in a way that (say) Swiss franc assets, which are more limited in availability, are not – this adds further to sterling's attractiveness.
Although it is comprised of just one country, the sterling currency “bloc” is the ideal safe haven for investors right now, and this will be evident further still when it trades up to 1.65 against the U.S. dollar in the coming months.
Everything is relative, and in a world of weak currencies the least ugly sister benefits.
Of course higher sterling is a hindrance to UK exporters, on whom the government is so reliant as it seeks an economic revival, but that is the paradox of foreign exchange markets – even an economy in recession can see its currency strengthen.
What of the land beyond 1.65 against the U.S. dollar?
This level is more or less where sterling’s mean-reverting fair value lies, so anything much higher – I target 1.72 – would not be long-term sustainable.
But FX traders are rarely in it for the long term….
Professor Moorad Choudhry is Treasurer, Corporate Banking Division, Royal Bank of Scotland.