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Sterling buoyed by manufacturing recovery

Created:

5 August 2009

Written by:

Chris Dillow

Sterling hit a nine-month high against the dollar this week, which helped push its trade-weighted index to its highest level since November.

The rise came amid signs that manufacturing activity is recovering around the world. Purchasing managers surveys in the US and UK showed new orders are rising at their fastest rate for two years, while similar surveys in the eurozone show that output is falling at its slowest pace for 13 months. "The worst is over," says Chris Williamson, chief economist at research group Markit.

But how can a worldwide industrial recovery benefit the currency of a nation that has relatively little manufacturing left, especially of the more cyclical sort?

The answer lies in global investors' attitudes to uncertainty. In uncertain times, they buy assets they feel familiar with, which tend to be dollars. But signs of a recovery are reducing this uncertainty. As a result, says Commerzbank's Ulrich Leuchtmann, the dollar is now losing its safe-haven appeal. So the pound has risen.

During the credit crunch this safe-haven effect has been tremendously powerful. Since the start of 2007 the dollar/sterling exchange rate has moved in lock-step with the S&P 500. Bad times for shares (rising uncertainty) have seen the dollar rise against sterling, and good times for shares (falling uncertainty) have seen sterling recover. The correlation between the two has been 0.96, with weekly moves in the S&P 500 explaining 92.4 per cent of weekly variation in the dollar/sterling rate.

However, it doesn't follow that further declines in uncertainty and rises in share prices will continue to boost the pound. One possibility, says Mr Leuchtmann, is that the dollar could recover. He says it has been depressed by concerns about its reserve currency status and fears about US inflation and government debt. But, he says, these worries are invalid - and as investors realise this, the greenback should recover.

On the other hand, though, sterling is still far below its five-year average against the euro, Swiss franc or Japanese yen. This suggests that financing constraints are still depressing the "carry trade" demand that supported sterling before the credit crunch. If such constraints ease, the return of such trades could give the pound a further lift.