The Sterling fall for the Euro

The pound is registering all-time lows against the euro (although admittedly the price history here only goes back to 1999).
It wasn't so long ago all the talk was about exploiting the strong pound with a Christmas shopping spree in New York. Back in November, sterling touched a high of $2.11, now it is 7.5% lower. The pound has also fallen against the euro, down 7% from November. The scale and speed of sterling's decline against European currencies is not quite on a par with the pound's eviction from the ERM in September 1992. In that instance, sterling plummeted from just below DM2.80 to below DM2.20 in a comparatively short space of time. The equivalent fall in the pound since January 2007 has been from around DM3.00 to DM2.40.
The scale of sterling's fall so far is not yet comparable, but the reasons behind it are familiar. A deteriorating economic outlook which can only be addressed through interest rate cuts, because the Government has reached its overdraft limit. A perception of poor economic management has grown since the credit squeeze hit the world last August. And capital inflows from companies buying UK assets have slowed sharply.
Britain is more vulnerable to a sharp downturn than other major economies. London is the international hub of world finance. The UK economy is more dependent on investment banking and related high-value financial and business services than almost anywhere else. Banking profits have been hammered by the sub-prime debacle and this will be felt in Britain's most profitable economic activity. Meanwhile, the downturn in the fortunes of the financial sector will have an adverse impact on property prices in the capital, which in turn will ripple out to nearby regions.
Aside from the financial sector, the other fast growing area over the last decade has been public sector employment. But because the money already has been spent in the years of plenty, there's nothing left in the public kitty. Public employment has stopped growing and real spending power for government workers will probably be squeezed substantially this year.
This lack of prudence has been in evidence since 2001. But recently there have been mounting concerns about the Government's ineptitude. Its unnecessary prevarication over Northern Rock is already well documented. What concerns me is the Prime Minister's control freakery contaminating the Bank of England.
One of Gordon Brown's two most enduring achievements as Chancellor was the decision to give the Bank of England formal operational independence in setting interest rates, the other was keeping out of the euro. But ahead of the Bank's January monetary policy meeting, the Prime Minister and the Chancellor both came close to openly calling on the Bank of England to cut interest rates. Moreover, in Parliament Gordon Brown ignored David Cameron's invitation to announce whether he was going to offer Mervyn King a second term as Governor of the Bank of England. King's five-year period in office expires in the summer.(Article continues below)Advertisement

This unwise interference and the less than wholesome support for the Governor was picked up by the markets. Had the Bank cut rates this month, as it was under intense pressure to do, it would have been interpreted as a clear 'political' move intended to keep Mervyn King in his job. All of a sudden the Bank of England's independence is seen as somehow 'conditional'. No wonder the pound is on the ropes.Ironically, the political interference back-fired. The Bank of England Monetary Policy Committee was well aware of the dangers of cutting rates in response to political pressure, and chose not to. Who knows, they may have been more inclined to agree to a cut if the Government had kept quiet. Whatever events complicate the monthly decisions, one thing is clear: UK interest rates are headed lower.
High interest rates are the principal means of support for the pound. UK official rates are currently the highest in the developed world. The official Bank of England repo rate stands at 5.5%, compared with euro rates at 4.0%, US Fed funds at 3.5% and Japanese overnight call rates at 0.5%. But in six months time, the differential between sterling interest rates and those of other leading currencies will narrow as concerns about the UK's financial industry and the housing market mount.
Sterling is also overvalued on what economists call 'purchasing power parity' grounds. If the prevailing exchange rate is £1=$2, then if $2 buys far more in the US than £1 buys in the UK, then you can say that the pound is overvalued against the dollar. At the current exchange rate of £1=$1.95 this is certainly the case.
In 1986 the Economist popularised this notion of varying purchasing power between countries by introducing a Big Mac index. It's a light-hearted guide to determine how far currencies are from fair value, i.e. when a Big Mac costs the same in both countries in dollar terms. On average a Big Mac costs $3.41 in the US and £1.99 or $3.90 in the UK implying that the pound is still overvalued by 14%.
And history maintains that the pound is on the high side against the dollar. Since 1985, when the pound reached a record low (close to parity), the average dollar exchange rate has been $1.65. When the pound is overvalued it has a strong tendency to slide quite precipitously. It seems that traders are regarding a bet against the pound this year in the same vein as they regarded a bet against the dollar last year.
This is not all bad news though. I have long argued that politicians should not regard exchange rates as a symbol of national virility. Rather it is a very useful adjustment tool. Consider the predicament of the UK economy. Consumer spending and the financial services industry are heading for a phase of retrenchment; the Government is up to its borrowing limit, so the only outlet available for expansion is exports. A depreciation of the pound will do no harm in this respect, by making British exports more price competitive.
The downside is that a fall in the pound will push up the prices of imports. The big unknown is whether this will feed through into generalised inflation. It didn't happen after the pound's sharp decline in 1992. But then the UK economy had plenty of spare capacity and commodity prices were not the inflation threat they are now. It is hardly surprising that the Prime Minister is calling public sector workers to accept tight three year pay deals. If there is a pick-up in industrial strife it will be another reason to sell the pound.
By Brian Durrant for The Daily Reckoning

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