Monday, February 09, 2004
Return of the $2 pound
Posted by David Smith at 08:26 PM
Category: David Smith' s magazine articles

When it comes to the currency markets, nothing is predictable. When the euro was launched at the start of 1999, many pundits predicted that the new currency would strengthen as central banks and institutions diversified their holdings away from the dollar.

The opposite happened. From a launch level of $1.16 against the dollar, the euro slid to just 83 cents. The pound also gained vis--vis the beleaguered single currency with the euro hitting a low of just 57p (not far short of a two euro pound), reinforcing another surprising trend in the foreign exchange markets – more than seven years of unexpected sterling strength.

The pound’s “re-rating” dates back to the summer of 1996. Sterling had been through a turbulent few years, beginning with “Black Wednesday”, September 16 1992, when it was forced out of the European exchange rate mechanism on a day of national humiliation (but considerable long-run economic benefit).

The pound lurched lower in the autumn of 1992, and it had another downward lurch about 18 months later. But in the late summer of 1996, despite the uncertainties of an impending change of government, the markets pushed it sharply higher, taking it above three D-marks in those pre-euro days.

Many of those moves of a few years ago have now reversed themselves. The euro has climbed against the dollar from that low of 83 cents to just below $1.30 at time of writing, a spectacular gain. Moreover, this has happened despite a woefully disappointing economic performance from the “euroland” economies and the collapse of Europe’s fiscal rules, embodied in the so-called stability and growth pact.

Sterling has come down from the heights in relation to the euro. From that low of 57p, the euro has climbed back to just below 70p. That has eased the pressure on exporters, although what they have gained on the euro swings they have lost on the dollar roundabout.

Until recently the pound could be relied on to stay in a range of $1.40 to $1.60 against the dollar, and usually at the lower end of that range. While sterling’s strength against the euro was uncomfortable, a fair rate against the dollar helped ease the strain.

That was until the dollar started falling. The dollar’s weakness, which has gained momentum in recent weeks, can be put down to several factors, not least the “twin” deficits, with America $400 billion in the red on its budget and a $600 billion gap on the current account of the balance of payments. In combination with US interest rates of just 1%, the arguments in favour of holding the dollar have weakened considerably.

More important than these, however, has been a change of attitude on the part of the American government. Seldom has economic policy in a major country been so geared towards a single aim, and that aim is to get George W Bush re-elected. If a significantly lower dollar helps in that aim, and gets the manufacturing lobby off the president’s back, so be it.

So the pound has strengthened, in a climb that has so far seen it rise into the high $1.80s, admittedly followed by a bout of profit-taking, with the smart money on the return of the $2 pound. Apart from a brief flirtation with this level in the early 1990s, this would take us back to where we were shortly after a fresh-faced Margaret Thatcher became prime minister in 1979.

What does a strong pound against the dollar mean, and how long will it last. Sterling’s strength, or rather the dollar’s weakness, is unfortunately timed. European economies remain weak, experiencing a low-key recovery at best. America, our biggest single market, is in contrast powering away. But the pound’s rise will make it harder to benefit from that economic strength.

The latest official figures show that Britain ran a record deficit of 10.2 billion on trade in goods and services in the September-November period of 2003.

They also show that exports to non-EU countries, of which America is the biggest, were down on a year earlier. Exporters have been doing well in the US market, so any reversal will be a disappointment, but the strength of sterling against the dollar may already be having an impact.

How long with sterling stay at this kind of level? Many currency forecasters think the dollar will stay weak for a long time, because the twin deficits will take years to work off. I’m not so sure. The Federal Reserve will soon be raising interest rates from the present very low 1% level. Not only that, but America’s greater dynamism guarantees more rapid economic growth than Europe over the medium and long-term. This will be reflected in the dollar’s level, possibly quite soon. In my view the dollar’s weakness is likely to be measured in months, not years. But it could be an uncomfortable few months for exporters.

From Industry magazine, February 2004

Comments

I think another factor is that the Chinese look like they are going to revalue the Yuan against the dollar. Although the dollar has fallen spectaclalry against the euro, its trade weighted real exchange rate has only fallen 9% - mainly due to the currency fixing of the asian countries. Release that and much of the trade balancing pressure on the dollar euro exchange rate disappears.

Posted by: Giles at February 15, 2004 12:55 AM

How would the dollar fare if the OPEC start selling their oil for euroes.
I s that a likely scenario, especially with escalating attacks on US citizens in Saudi and Iraq.

Posted by: KEV at June 25, 2004 11:32 AM