Piling On The Pounds

We spend a great deal of time here at Minerva talking about what‘s happening in the markets. Having scouted around for a story this time, however, Minerva‘s found it a little difficult to find anything that interests us. Yes, there‘s been a bit of merger and acquisitions news and there‘s the usual rumours and opinions being bandied around; but to be frank, we hadn‘t found anything we considered to be worthy of our usual inquisitiveness. Until, that is we considered the subject of currency.

You‘ve probably noticed that sterling has been flirting with the $2.00 to the £1.00 mark for a while now, although it hasn‘t yet broken through. Although, we haven‘t got the time or the inclination to get into the dark arts of currency trading and speculation here, we can identify two significant reasons for the pounds strength against the dollar (and indeed a raft of other currencies).

The first reason, and the one which is perhaps most easily identifiable amongst lay people, are the recent increases in UK interest rates. This increase in the cost of borrowing has the effect of strengthening the pound. Central bankers in the US, Eurozone and Japan have not been as aggressive in raising rates as their UK counterparts.

A second reason is a move by central bankers to diversify their currency reserves, creating a greater demand for liquid currencies like sterling and the Euro (the Euro too has strengthened significantly against the dollar).

So where now for the pound? Well, if one accepts that there is inflationary pressure, then the ‘real‘ rate of interest will fall until the Bank of England raises rates to counter it, which it has just done - spurring an increase in the value of sterling. However, if this rate rise proves successful in curbing inflation, then the nominal rate i.e. the one which they announce every month, should begin to fall again, thus potentially weakening the pound and making it‘s current relative strength short lived.

If we look at the currency diversification argument, we can see more evidence that the pounds relative strength may not continue over the long term. In an increasingly global economy, the UK behaves in a very similar way to many of the large industrialised economies, particularly that of the US. A significant proportion of the growth in the UK economy over recent years has come from the banking, financial and property sectors, especially within the City of London. In this sense, a play on sterling is partially a play on the City and as the keen observers among you will remember the City has had its good times and its bad times. So if things start to look less rosy for the City, so too they could for sterling.

Simple? Not quite. Current account deficits, trade balances, consumer debt and a host of other fundamentals also influence currency valuations. And these...well, according to US banks Goldman Sachs and Lehman Brothers, they point to sterling being significantly overvalued.

[This section was compiled using data and information obtained from BBC Online, Trustnet.com, Money Week and Credit Suisse Plc].