August 15, 2008 | posted by Michael Baxter in Sterling | comments (0) |

The pound closed in on its lowest value against the dollar in almost two years yesterday; meanwhile, in the US, inflation hit a 17-year high. The two are connected, and their connection throws light on what may well happen next as Stage 2 in the credit crunch unfolds.

Economists once coined the phrase Dutch Disease to describe what happens when an economy’s currency is driven so high by one particular sector – in the case of Holland it was oil – that the rest of the economy is rendered uncompetitive. Well, in the UK too, oil drove up the price of the pound. Such was the jump in sterling and the resulting loss of competitiveness for UK manufacturing that some have argued North Sea oil was a mixed blessing for the UK.

The pound surely stopped being a petro currency two or three years ago now, yet it stayed high. It stayed high despite surging consumer spending, and the resulting massive deficit in the UK’s current account. Many have argued, including this publication, that sterling is due a sharp correction.

For the last few years, though, it seems that the pound ceased being a petro currency and became a kind of bankers’ currency instead. Money surged into the UK, and was lent to British banks and business at low interest rates. The UK was considered low risk, so money lent to the UK carried a low premium.

The UK, on the other hand, enjoyed much higher returns on assets its citizens held abroad.

But during the credit crunch, this changed. Post credit crunch, presumably it will change some more. Less money is flowing into the UK, and much of the money that is coming in is being invested via sovereign wealth funds into buying assets on the cheap. The result will be a much greater flow of dividends leaving the UK in future years.

It seems then there are good reasons to think the pound has been due a correction, and that once corrected the change will stay in place for the foreseeable future.

It may be this correction is what we are witnessing, right now.

The pound has of course been falling against the euro for some time, but until recently actually rose against the dollar. Now even this has gone into sharp reverse.

It seems likely that the main reason why the pound initially gained against the dollar, even though the two economies have similar structural problems, is that the US economic cycle is 18 months to 2 years ahead of the UK. Maybe we are now simply seeing the UK experience the kind of falls the US suffered from earlier in 2007.

It is both good and bad news. It is bad news for Brits travelling abroad, and it is bad news for inflation. As the pound falls, foreign goods become more expensive, pushing up prices yet again. This will in turn make it much harder for the Bank of England to lower interest rates.

On the other hand, our exporters should experience a healthy boost as a result. It won’t happen straight away, for as long as the Eurozone is contracting, it is difficult to see how the UK can enjoy export-led expansion. But if the Eurozone recovers, as was predicted in the article above, the result will then be surging exports.

The pressure a falling pound will exert on the Bank of England to up interest rates may be a good thing in the long-run too. The savings ratio in the UK is too low. It may be that this can only be corrected through higher interest rates – well, that and a shortage of credit. So a weaker pound will at least help in that respect.

But it is difficult to see how the UK economy can continue to expand if its high-spending consumers turn to thrifty savers.

That is why exports are so important. And that is why the telling point will be how rapidly the Eurozone can recover, in an environment where its two main external customers are losing steam.

As for the dollar, this has of course risen sharply in recent days, not just against the pound, but against the euro. This has largely been caused by the bad economic news from the Eurozone and Japan.

But, if the analysis above on an imminent Eurozone recovery is right, the dollar’s resurgence may be short-lived, at least against the euro – maybe not against the pound.

US inflation hit a 17-year high in July. The annual US consumer price index was 5.6 per cent higher than a year ago last month. Prices surged by 0.8 per cent in July alone. Even if you strip out food and energy, prices rose by 0.3 per cent in the month.

Then again, with oil and food falling in price, there are good reasons for thinking the index will fall soon. For that reason, it seems unlikely the Fed will tighten interest rates.

The US is simply seeing the same inflation picture that the rest of us are experiencing. The fight against inflation is in full flow. It is being fought in the form of falling real income levels, meaning the resulting fall in demand will lead to lower prices in the future.

The US has avoided recession so far, and the Eurozone experienced recession for two simple reasons. The US government gave out a huge tax credit – something that most Eurozone governments are unable to do because the EU Stability Pact does not allow them the scope to up their borrowing by the amount required to fund this credit. Secondly, the ECB has been much firmer with inflation.

There is one of two possible outcomes. Either the ECB has been foolishly tough on inflation and the Stability Pact is unnecessarily restrictive with its rules. Or rather, this tighter approach will pay dividends in the longer-term.

Right now, it seems the odds are with the latter possibility; this suggests the Eurozone will recover while the US and UK remain in the doldrums. If that is right, then presumably the dollar will fall back against the euro.

August 13, 2008 | posted by Michael Baxter in Sterling | comments (0) |

So the world re-aligns. The US and UK see the consequences of all those years of borrowing. And the rest of the world look on, and thank their lucky stars their own economies were based on producing things. But all of a sudden, it looks different. France joins Germany, Italy and Spain in the recession-fears club; Japan stutters; China changes; and we wait and see whether the recent trend seen of falling oil prices continues, and if it does continue, what this means for Russia.

And as all this happens, the dollar turns from being yesterday’s whipping boy, to the big buying opportunity.

The dollar is now at its highest price relative to the euro since February; relative to sterling it is at its highest price since November 2006. And the change really is like clockwork.

If you believe that the UK economy lags around 18 months behind the US, then the timing is about right – maybe a touch late, but the right ballpark.

In some ways the recent falls in the dollar against sterling seemed a touch odd. After all, the UK has suffered from similar problems to the US – massive current account deficit, over-indebted consumers. It is just that the US suffered first.

But what we are really seeing now, though, is something quite curious.

The dollar has fallen because the US economy needs to export its way out of trouble. This has gone into reverse, partially because the rest of the world can’t afford to let the US export its way out of trouble.

So, if the dollar continues to rise, US exports will fall, and the US economy will weaken again.

The world needs to see two things happen. It needs to see oil, food and other commodities fall in price – and it needs to see the Chinese consumer continue to spend more. If neither of these things happens, then it is difficult to see how the current economic crisis can improve any time soon.

August 11, 2008 | posted by Michael Baxter in Sterling | comments (0) |

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.

January 29, 2008 | posted by Michael Baxter in Sterling | comments (0) |

There is a mystery a-brewing. US interest rates are falling like a pig, shorn of its wings, from the sky. And yet the dollar has not fallen in tandem. If you take into account interest rate expectations, then this really becomes quite surprising. Fed chairman, Ben Bernanke, has metaphorically chartered a fleet of helicopters carrying monetary stimulus to try and boost the US economy, but, by contrast, the central bank in the UK still seems to be fretting over inflation and this moral hazard argument – that banks are being bailed out through encouraging them to do more of the same things that created the mess in the first place.

Put all that together and it would appear the gap between US and UK interest rates is set to climb.   Then take into account that Until March last year, US and UK interest rates were the same. Then the Fed lowered rates while the Bank of England raised them.

In the short term there seem to be two main reasons for money to flow into a country. Money will flow in to chase higher interest payments, and it will flow in if the recipient country is seen to be having good economic prospects.

Bear that in mind, and all of a sudden the reasons for the sharp fall in the dollar relative to the pound last year become clear.

But the pound has since dropped back, falling from $2.10 last autumn to this morning’s price of 1.98. So if the expectations for US interest rates are so low, while at the same time the outlook for the US economy seems awful, why has the pound weakened?

It seems there are three possible explanations. Explanation 1: markets believe the Bank of England will change its tune, and will soon join the Fed in a race to see who can cut interest rates the quickest. Explanation 2: markets expect the UK economy to go the way of the US, and slow, possibly even toying with recession. Explanation 3: things are actually working the way the economic text books say they should, and the pound is at last responding to the fact the UK suffers from a massive deficit on its current account.

Recently, the deficit in Britain’s balance of payments current account as a percentage of GDP overtook the deficit seen in the US, but even that doesn’t tell the full story. One theory doing the rounds is that the official figures on Britain’s balance of payments deficits understate the reality, because the figures don’t accurately reflect the extent to which UK company profits have occurred overseas.

It was about this time last year that Warren Buffett said he was getting out of dollars; there was no magical reason for his decision. He decided the US current account deficit was too high.

Economists have for some time dismissed current account deficits as not really mattering  if capital flows into the country with the deficit increase.  It is certainly the case that both the US and UK are on the receiving end of massive capital flows.

Maybe, though, investors have become more discerning. Sovereign Wealth Funds are demanding an awful lot more bang for their buck, while the dollar and perhaps the pound have lost much of their appeal to investors.

Maybe this is the true reason for the credit crunch, foreigners are no longer happy to pump money into the economies of the Anglo Saxon world for such a lousy return.

And what is the lesson for this story? It is that in the long run, deficits in the balance of payments current account do matter, after all. For years, economists have dismissed as groundless, fears that the US balance of payments deficit would end in tears, saying this was as about as likely as pigs flying. Well, it seems that just may have happened. The economic pig may have taken to the wing.  

December 20, 2007 | posted by Michael Baxter in Sterling | comments (0) |

“It ain’t the rate of interest that’s the problem,” said Airbus Jean-Claude Trichet, yesterday, “it’s the lack of credit.”

You will recall, yesterday, the President of the European Central Bank took Helicopter Ben (Bernanke’s) idea for solving a credit crisis by scattering money across the land a step further. Mr Trichet and his ECB cohorts announced an extraordinary 349 billion euro cash injection, propting us to nick-name him Airbus Jean.

You would have thought, after pumping all that money out there, the ECB would be lowering interest rates soon. But yesterday the great cash splatterer told the European parliament “the risks to price stability over the medium term are clearly on the upside.” He also said that price stability requirements and the need to get banks to start lending again are separate issues.

Naturally, banks and commentators saw red at those words. Kevin Gaynor, Head of Economics and interest-rate strategy at RBS in London told Bloomberg “It can’t have temporary support for the market stretching into six months and yet maintain the fig leaf that monetary policy is based on an unchanged view of economic risks.”

But, Mr Trichet could be right. The crisis we are seeing at the moment is not down to official interest rates, it’s down to market interest rates. Central banks want us to lend and borrow at one rate. The markets are forcing this level higher although, by the way, interbank rates do seem to falling.

Meanwhile, in the US, Federal Reserve Bank of Richmond President Jeffrey Lacker said “Because the job of a central banker is to protect the purchasing power of currency, it is overall inflation that we need to keep down, not just core inflation…I am uncomfortable with the inflation picture.”

Yet, in the UK, after the Bank of England dropped a size 10 hint that interest rates are going to fall several times next year, markets started to work out the ramifications.

The pound fell. At the time of writing it stood at $1.99, the lowest level since June. We predicted yesterday that if the Bank of England really does slash interest rates next year, the pound is likely to be the casualty.

Not that this would necessarily be a bad thing. If the UK could find it is able to export its way to growth, that would be be good news indeed, although it could lead to more inflation.

But was we have said before, when both the US and UK suddenly start importing a good deal less, but export more, it is naive to believe the global economy can just carry on regardless.