August 11, 2008 | posted by Michael Baxter in Sterling |

Which way next for the currency markets. Everything seemed to flip on Friday – with the dollar the star of the moment, talk that the euro has had its day, and sterling left somewhere in between. So, what next for the pound?

If there is a word for 2008, then that word may well be schadenfreude – to take pleasure at others’ misfortune. Barely a day goes by without at least one newspaper article mentioning this ‘s’ word. But Friday saw schadenfreude hit a new level of absurdity, as markets in the US celebrated over news that the Erozone could be heading for recession.

The Dow soared by 302 points, taking the index to its highest level in about 6 weeks, and yet there has been no improvement in the economic outlook for the US. On the contrary, losses incurred by US banks show no sign of going into reverse. Consumer confidence is diving faster than any athlete in the Chinese Olympic diving pool could manage, the economic benefit from the US tax credit is slowly ebbing away now, and many economists believe 2009 will be the worst year yet for the US in this sorry tale of economic crisis we are seeing at the present.

And yet the Dow soars. And it soars because the news from Europe is so bad.

Jean-Claude Trichet, president of the European Central Bank said on Friday that Eurozone growth in the third quarter would be “particularly weak,” and as a result traders in the US couldn’t buy stock fast enough.

Why is that? All of a sudden, the euro is losing its attraction. While all the bad news was being restricted to the US and UK, currency traders jumped on the euro. Speculation grew that the euro was set to replace the dollar as the world’s premier currency, and the foreign reserve of choice. It was easy to see why; with the exception of countries such as Spain and Ireland, the Eurozone has stayed clear of an unsustainable debt bubble. Not for the Eurozone, growth based on borrowing. Instead, it was doing things the old-fashioned way, through producing goods and services the world wanted. But then a slow trickle of news that the region was not doing quite as well as expected turned into a raging torrent. Italy appears to be in recession now. The house price crash in Spain makes the UK housing market downturn more akin to a walk in the park, and now we hear that Germany may have seen a contraction in the quarter just gone.

And the deteriorating conditions in the Eurozone spelled crisis for the euro. The dollar saw its biggest one-day rise against the euro in eight years.

All of a sudden the view emerged that the Eurozone bull run was over. That it was time for the greenback to make a comeback. And that is good news for US stocks. Okay, the prognosis for US corporate earnings is not especially rosy, but, if the dollar is rising, then at least US company profits valued in euros may be improving, or at least not falling so fast.

Mind you, the big dollar buying spree on the back of Mr Trichet’s comments was a tad slow. It has been becoming more and more obvious that the economic outlook for the Eurozone was worsening for some time. See, for example, the falling Economic Sentiment Indicator, first shown here over a week ago.

As for sterling, it gained slightly against the euro too, but didn’t do as well as the dollar. In fact, at the time of writing, there are 1.92 dollars to the pound; that is the cheapest the pound has been relative to the greenback for many months.

It does seem that the currency markets may have quite an interesting time ahead.

At the moment, rising inflation in the developing world would suggest that the authorities in countries such as China should appreciate their currencies fast. On the other hand, if inflation in these countries sets in, there will be pressure on the currencies to fall.

This was the experience of the pound, of course, from 1967 onwards, when the Harold Wilson government devalued sterling. The UK suffered more severe inflation than its economic rivals, making British goods more expensive, forcing the pound to fall even further.

As for today, sterling is sitting in an intriguing position.

It has been argued here many times that the pound will fall eventually – and the recent falls in sterling against the euro have helped support this view. But the appalling news from the US seen this year has meant that, against the dollar, the pound has remained very strong.

But one of the issues that has protected sterling over the last few years, despite the massive deficit on the balance of payments current account, has been the massive flow of money into Britain. At the same time, Britain has benefited from a curiosity.

For some time now, the value of assets held by British investors abroad has been lower than British assets held by foreigners. Given this, you would have expected a negative flow of interest and dividend payments. But, in fact, the opposite has happened. It seems the reason for this is that foreigners were investing in low risk British bonds – especially government bonds, while the British were investing in higher risk overseas assets, which yielded a better return.

But, the credit crunch does of course mean big chunks of UK PLC are being sold off on the cheap. In the longer-term, this will surely lead to a big rise in dividend flow out of the UK, which will surely lead to massive pressure on sterling to fall.

The dollar has seen massive falls over the last 18 months or so. There are reasons to believe these falls could be near an end. But the UK and US economies are similar in so many ways, yet the pound has not risen anywhere near as fast as the greenback. Maybe the pound is about to play catch up.