Comments: Fear of falling dominates the outlook

Alternative thoughts on your sterling comments.

Interesting observation on the distortion in the Q3 current account data. What about the basic balance though which has shown a large deficit in recent years? Does this make sterling very vulnerable to short term capital outflows as the base rate is steadily cut and the positive interest rate differential with the other major currencies is eroded?

Or looked at from a different angle, currency movements have moved in an opposite direction to that predicted by interest rate arbitrage. If the yen carry trade breaks down as the world becomes more risk averse, won't this undermine high yielding currencies like sterling irrespective of the domestiic growth slowdown?

Finally, sterling traded betyween 0.64 to 0.70 against the euro until last year, closly hugging its pre ERM withdrawal mid-point. The breakout to 0.74 already represents a material breakdown in the currency and is consistent with the stronger basic balance in the euro area, as well as the convergence in growth rates.

Posted by Ian Macfarlane at January 6, 2008 01:06 AM

You make a fair point. Basic balances have not been a great predictor of exchange rate movements in recent years but if capital inflows into the UK are to fade then they will be more influential. My argument is that the markets may have become slightly too convinced of the euro's hard currency status, partly because the ECB is perceived to have done well during the credit crisis and partly because of its unwillingness to cut rates. Some of this perception will unwind, I suspect, as strains in the eurozone economy emerge and pressure on the ECB to cut grows.

Posted by David Smith at January 6, 2008 11:29 AM

The last cut to 5.5% from 5.75% was only politically motivated. It says a lot about the BOE and its independent and also it says a lot about the fact that the UK it woul;d appear are patantly unable to cope with a historically low rate of 5.75%.

Rates should be higher to curb the debt fest that has ensued since 2001 and should inded not have even been lowered in the aftermath of 9/11. But, there we are hindsight is a wonderful thing...

Posted by Pete Balchin, Solicitor at January 6, 2008 11:48 PM

Sterling is likely to get flattened over the next two years. The true state of the UK economy is becoming apparent now, and the markets are beginning to price it in. (I've moved all of my assets that weren't already in EURO (most of them) into CHF, silver, and Yen in anticipation of the trouncing.)

The residential property market is now earnestly beginning to follow the commericial market into crash mode. The politically motivated Bank will lower rates to counter this, but it is unlikely to work. Sterling will fall significantly (against a basket) as rates fall. The statisticians at the Bank and treasury will have their work cut out for them as the try to show that inflation is (fictitiously) still constrained. RPI will continue to diverge from CPI. Maybe Gordon will introduce a new 'core' inflation measure to get rid of those inconvenient energy and food price issues! Falling property values will reveal how important rising values were to consumption. Consumption will plummet. The UK will be in recession by 2009. By mid 2008 the sterling exchange rate will fully reflect this reality.

Gumbrell

Posted by T Gumbrell at January 7, 2008 01:06 PM

Not much point commenting on that lot, except that in the scenario you sketch out RPI inflation would fall very sharply, probably dropping below CPI inflation. Maybe that's what you meant by divergence.

Posted by David Smith at January 7, 2008 02:01 PM

David, what's the distortion on overseas earnings that you mention in your article? From eyeballing the data and reading the ONS's comments, it's not obvious what this is. Thanks.

Posted by Sell Everything at January 7, 2008 03:02 PM

Your point about the markets taking the euro's hard currency status on board too strongly is well made. I wonder how long we will have to wait for the ECB to lower rates though.

Some members of the Governing Council see inflation has a temporary bump that will be corrected by lower growth. However, the ECB operates on consensus rather than a simple majority vote which almost guarantees they will remain behind the curve. There are a number of issues that could prevent broad agreement emerging in the short- term.

First, the Council seems haunted by fears of second round effects. Second, growth is unevenly spread across the region. Third, the money and credit aggregates have yet to reflect the credit crunch.

So a rate cut may have to wait for inflation to peak and start falling and for growth to drop well below trend across the region. This may only occur later in the year.

On the other hand, the ECB was equally hawkish in 2001 and was cutting rates agggressively 6-months later. Admitedly corporate and household cash flows were in much worse shape then. But the ECB is nothing if not pragmatic, as their response in injecting liquidity at an early stage of the credit crisis demonstrates.

It should make for a volatile time until they do cut rates, though how much of a premium over the fed funds rate can they withstand.

Posted by Ian Macfarlane at January 7, 2008 03:36 PM

On the balance of payments, it may be no more than a hunch, but I suspect some of the sharp deterioration on the income account in the third quarter reflects immediate credit crisis distortions. The ONS also attributes some of it to the strength of sterling and high UK interest rates, some of which has faded as a factor.

Posted by David Smith at January 7, 2008 03:45 PM