Sterling has risen to its highest level against the euro since November 2008. It is also near an 11-month high against the yen, and a nine-month high against the US dollar. Thanks to this, its trade-weighted index is at its highest level since August 2009.
It’s easy to see why – after the fact of course! – it should have risen. Recent figures – most notably March’s retail sales data – suggest that the UK economy avoided recession in Q1, beating some expectations. By contrast, purchasing managers’ surveys suggest the euro zone’s recession is deepening, dashing hopes of an early recovery, whilst the recent US jobs report cast doubt upon the strength of the US’s upturn. Adam Posen’s decision to stop voting for more quantitative easing gave a further lift to the pound.
Two things suggest this strength might continue. One is that there is no great reason to expect a nice surprise from the euro zone’s economy. Martin van Vliet at ING says the region is in “dire straits” and that whilst he expects a recovery in the summer, “the risks are clearly skewed to a more protracted recession.”
The other is that, just as there is momentum in shares, so too there is in currencies; ones that have risen tend (on average) to continue to do so. Lucio Sarno at Cass Business School has found “large and significant” profits to momentum trading in currencies. This might be for the same reason that there is momentum in shares. It could be that traders under-react to good news, causing the currency to not rise initially as much as it should, with the result that it drifts upwards later.
However, there are also (at least) three good reasons not to be bullish of sterling.
First, our economic recovery is not certain. It’s likely that some of the strength in retail sales in March was due to the unseasonably nice weather causing a rise in spending on spring clothing and gardening supplies. But such sales merely come at the expense of April’s spending, so next month’s numbers might show a fall. Also, with companies still preferring to pay off debt or build up cash, a big improvement in capital spending or employment is unlikely. And then there’s the danger that our extra bank holiday in June could reduce output.
Secondly, we have not returned to the pre-crisis situation in which sterling got a huge lift from carry trades. The pound’s interest rate pick-up – half a point over the US dollar and a quarter point over the euro – is not so great as to reward traders for taking on the risks involved in carry trades.
Thirdly, the Bank of England might not welcome the pound’s rise. So far this year, its trade-weighted index has risen 2.5 per cent. According to the old “four for one” rule (which says that a four per cent rise in the pound represents a monetary tightening equivalent to a one percentage point rise in Bank rate) this is equivalent to a half-point rise in Bank rate. But it’s not at all obvious that the economy has improved so much as to warrant such a tightening. This means that if sterling does look like rising further, QE might come back onto the agenda. This would cap its rise.
It is, therefore, unclear whether the pound’s strength can last. And this highlights what is for me the first rule of currencies – that nobody knows much. Yes, banks have sometimes made money in FX trading. But as the work of Martin Evans of Georgetown University has shown, this owes more to their knowledge of order flows than it does to macroeconomic models, as these have, at best, a patchy record in explaining or predicting exchange rate moves.
So, whilst investors should certainly be aware of the risk that sterling could rise further – which would be slightly bad for export-oriented stocks and for investors with large overseas exposure – it would be unwise to base one’s investments upon any view of future currency moves.
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Chris blogs at http://stumblingandmumbling.typepad.com