Currencies: Traders' affection for sterling hits new heights

Foreign exchange traders are still snapping up the pound, undeterred by the prospect of the first Labour government since 1979. The currency reached its highest level for four and a half years against the German mark last week.

They're betting on the new leaders boosting interest rates soon after the election to cool the economy and prove their inflation-fighting mettle.

"Rates will go up after the election, keeping sterling strong," said Tom Barman of Rothschild International Asset Management. "The fundamentals suggest there should have been a rate increase already."

The British economy grew at annual 2.6 per cent rate in the fourth quarter of last year, outpacing its continental neighbours. And most evidence suggests that growth has not slowed in the past three months.

Interest rates have been left unchanged since last October, in the run- up to the election. This makes it more likely that the probable Labour Chancellor, Gordon Brown, will choose to raise them, perhaps as soon as the next monetary policy meeting on 7 May.

Labour pledged in its election manifesto that it would match the Conservative government's goal of getting the annual inflation rate down to 2.5 per cent or even less. The rate fell to 2.7 per cent in March from 2.9 per cent in February, although gains in earnings and employment in March fuelled fears that inflation may accelerate again.

Traders are speculating a half-point increase in rates might now be necessary, which could mean bigger gains for sterling. The pound has already risen 22 per cent since August, to a high of Dm2.8246 last Tuesday.

On 7 April, sterling broke above its former floor in Europe's exchange rate mechanism of Dm2.778 for the first time since Black Wednesday - 16 September 1992 - when the British currency quit the currency grid. Since then, it's held above the old floor.

Brian Martin, senior currency strategist at Barclays Bank, reckons the pound could climb to about Dm2.85 to Dm2.90. "Our view is that base rates will go to 8 per cent in the early stages of 1998."

Higher rates and a stronger pound spells difficulty for Britain's exporters. Reuters and Reed added their voices last week to the many companies which have already said earnings were suffering because of the currency's rally.

"The rapid rate of sterling's appreciation has made it difficult for exporters to adjust to the rise," said Keith Hopkins, chief executive of Croda International.

The UK chemical company receives about one-third of its annual revenue from export sales, mostly in marks. "Most of our main competitors are based in Germany," he said.

Eddie George, Governor of the Bank of England, conceded two weeks ago that there was a conflict between needing higher interest rates in order to keep domestic demand from overheating, while exporters struggle with the overall effects of a stronger pound.

"A firming of our monetary policy would clearly be unwelcome to UK exporters," he said.

Still, George said the best that British authorities can do is to "make appropriate allowances" for the effects of sterling's appreciation on future demand in determining monetary policy.

Traders took that remark to mean that policymakers' main focus will be on fighting inflation, which stands to benefit sterling.

"It will take a little bit of time for the new Chancellor and the Governor of the Bank of England to work out a dynamic, but the bank will still want rates to go up," Mr Barman said. Copyright: IOS & Bloomberg