Economic View: More than fashion is driving the surge in sterling
Tuesday 04 June 1996
For example, against the US dollar it has risen from around the $1.50 level to nudge towards $1.55. While that may not seem not enough perhaps to make holidays in America seem much cheaper, it is enough to require some sort of explanation - particularly when you note that this is not a dollar-related phenomenon, but a rise across the board.
In fact, if you take the trade-weighted index, sterling is at its highest for more than a year.
After languishing in the 82-83 region throughout the winter, it has suddenly shot up to above 86 (see left-hand graph).
So what is the explanation, and what are the further implications, if any, that follow from that?
The shift is very recent, so any explanation is going to be a rough-and- ready one, but it is evident and secure enough for there to be something more than pure fashion as a driving force, though fashion, as argued below, has played a part. It is perhaps most helpful to divide the drivers into three parts: economics, finance, and politics.
Economics first. The main short-term impetus from economic factors usually comes through the impact of growth on interest rate differentials: higher- than-expected growth leading to higher-than-expected short-term interests rates, which make the currency a more attractive place to park spare cash.
There is not much of a shift of perception here, but there may be some marginal impact from recent data. Last week the OECD revised down its UK growth forecast, but that reflects the flow of information in the first three months of the year rather than the most up-to-date data. Since March it has become more clear that the UK recovery will be sustained through this year by the consumer, something not yet evident in Germany or France.
Money supply, consumer lending, house prices and so on all support the idea that there will be a UK mini-boom through the autumn, which should be pushing up base rates by the spring, if not before. By contrast, the first rise in German interest rates could be 18 months off.
This is not a strong signal of growth, and it is based on an intuitive reading of the figures rather than a conventional number-crunching one.
Number-crunchers are still impressed by the lack of growth in manufacturing. But for anyone who wanted to buy sterling anyway, the economic data would give some additional comfort.
Switch to financial factors. One of the principal reasons why potential investors might want to look at sterling lies in its value. By that I do not mean its purchasing power parity, though that - for the very long- term investor - is always a further comfort. Rather I mean the "value- for-money" available in financial assets.
All major bond markets follow pretty much the same profile in the sense that the big shifts in global bond prices are much more important than the relatively small shifts between prices in each of the major markets. You can see how closely UK gilts and German bunds have moved over the last year in the right-hand graph.
Both have swung about, but the gap between the two has remained more or less constant. Timing of entry into the global market is much more important than the choice of the individual market.
Nevertheless, within Europe there has been a shift of sentiment in recent months towards the "high-yielders", the bond markets of the softer European currencies, on the grounds that if there is not much currency risk, why accept a yield of, say, 7 per cent, when you can get one of 9 per cent.
This has benefited the assets of countries on the periphery of Europe: Nordic bonds, and Italian and Spanish ones. In the last few days there has been some feeling that UK bonds, which fall somewhat between these high-yielders and the core bonds of Germany and France, have been neglected.
Some of sterling's strength may be a reflection this change in the fashion of financial markets, and of course the more the pound does strengthen, the greater the return on sterling-assets for an overseas investor.
But to say there has been a shift of fashion in financial markets begs the question of why this should be. Here perhaps the best answer lies in politics, and in particular a reappraisal of what might happen to UK markets under a change of government.
The standard perception in the UK is that, on balance, interest rates and inflation would be slightly higher under a Labour government than a Tory one.
It would follow that a change of government would be bad for sterling and bad for gilts. In the UK this view may still hold, but abroad perceptions may be different.
The bull case for a Labour government would have several elements. One would be that, by European standards, a Labour government would be more "normal" than the present Tory one.
One does not need to make a judgement on the wisdom of the present government management of its relations with Europe to note that it is behaving in an unusual way. A Labour government would be easier to understand.
A second rational argument for a bullish view would be Labour policy on an independent Bank of England, where it has made a firm commitment.
Overseas investors in UK bonds do not need to make judgements about trends in growth, efficiency, labour markets, enterprise or any of the other things which concern the UK business community.
They are interested solely in the return on bonds, and this is mainly determined by long-term inflationary prospects.
The lower the inflation, the lower the long-term interest rates and the higher the currency.
The more independent the Bank of England, other things being equal, the more likely the UK is to improve its relative inflationary performance.
A third rational argument in favour of a change of government (again from the perspective of an overseas investor) lies in the way in which the present one seems to have stoked up a mini-boom this autumn. The logic, which may seem slightly convoluted, runs like this. Here is a British government up to its old tricks, trying to inflate its way into popularity.
So a different government would not be any worse and might even be better for investors in UK bonds. The very behaviour which has prompted the weakness of the pound over the last few months increases the argument in favour of a change of government.
Whether this revisionist view of financial markets under a possible Labour government is right or wrong is irrelevant; nor does it really matter that it is hardly a mainstream perception. The fact that it is being articulated at all is interesting and new.
Put these together and what emerges is by no means a strong "buy" signal for the pound. Few people are suggesting, yet, that the long-term post- war secular downtrend in the pound is about to be reversed. (The case for that is much more complicated, relying on differential demography, pension liabilities, trends in competitiveness and so on.) Rather it is that, looking around the world, sterling at its present level does not look too bad a buy.
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