This pattern of behaviour has radical implications for the prospects for sterling and UK interest rates. For example, over the past three months we have had two base rate cuts. But the implied level of interest rates in 2001 and 2002 has risen by a staggering 150 basis points. This can be entirely explained in terms of sterling's link with the dollar and the shifting influence on London markets from European versus US interest rates.
The charts show a simple scattergram of the overall value of sterling versus the dollar and the euro. They show a clear positive relationship with the dollar, with the correlation close to 100 per cent, suggesting that a 5 per cent move in the dollar is accompanied by an almost equal move in sterling. The sterling exchange rate index is a weighted average of our exchange rate against a range of other currencies, including the dollar. We would normally therefore expect to see such scattergrams indicating a negative relationship, reflecting the significant weight of the two currencies in each other's index. This makes the relationship all the more striking. If we repeat the exercise for sterling versus the Deutsche mark or the euro, the relationship is indeed firmly downward. Of course, simple charts like this do not tell us anything about causality - they show merely that a rise in the dollar is associated with a rise in sterling. Yet no one would seriously propose that movements in sterling cause movements in the dollar.
The causality must go the other way. Since the beginning of the year the dollar exchange rate index has appreciated by over 5 per cent, dragging sterling with it. At its simplest, this argument suggests that, had the dollar been stable this year, sterling's overall value would have been 5 per cent lower. Against this background, the Bank of England's Monetary Policy Committee would almost certainly have called a clearer halt to their easing and many commentators would be suggesting that base rates would start rising before Christmas. This does not, of course, mean that sterling always moves in step with the dollar. But the volatility of its value against the US currency has been much lower than against the euro (or its predecessor currencies).
Strangely, this phenomenon is not fully reflected in the market for foreign exchange options. These fancy financial instruments actually allow transactions to occur, not merely in the level of currencies, but in the volatilities themselves. This market prices the volatility of sterling against the dollar at a roughly similar price to that against the euro. As this pattern of behaviour is increasingly shown to be the wrong one, the prices must surely diverge.
Another implication of this is that in order to forecast sterling, one has to form a judgement about the dollar. Indeed, the dollar would seem to be the dominant influence on the value of sterling at present. It provides the solution to the puzzle of why the pound has remained so strong over the winter period, when growth and interest rates in the UK collapsed relative to those of our international rivals.
Our head of foreign exchange strategy, Michael Rosenberg, believes that the dollar is likely to remain firm over the rest of this year. Against this background, it is unlikely that sterling will weaken. This suggests that the MPC may cut rates further. Indeed, although we share the consensus that rates probably have troughed, if the dollar remains firm we put the chances of a further cut this year as high as one in three. But, whether or not there are further cuts, we are sticking to our view that base rates rise next year to 6 per cent. Some mortgage banks are still offering fixed- rate mortgages based on the level and structure of rates a few months ago. Borrow now while stocks last is the message!
The increasing influence of the United States is also evident in the market for government bonds. Ten years ago the dominant international bond market for the UK was US treasuries. As we prepared to join the ERM, the German bond market became increasingly important and the influence of US Treasuries died away. Even after we were blown out of the ERM, the prospect that we might join EMU gradually rebuilt the influence of the German market. Since 1996, however, that influence has gradually waned to be replaced by an increasing tug from the US. Fluctuations in UK government bond yields are now equally sensitive to movements in the US and Euroland.
This phenomenon is also evident at shorter maturities around the five year mark. Why does this matter? These interest rates are a critical influence on fixed-rate mortgages. In any case, monetary policy decisions taken in Washington will be more important for your future mortgage rate than the judgements in Frankfurt or even London.
Steven Bell is the chief UK economist at Deutsche BankReuse content