In the past six months, sterling has gained 5% and 8% against the euro and dollar, respectively.
A rising interest-rate differential has been crucial. Forward markets now price sterling three-month interest rates in one year?s time at 4.8%, up 130 basis points since the Bank of England?s Monetary Policy Committee (MPC) last cut rates in July 2003. Eurozone forward rates have fallen 30bp in that time to 2.2%. So the yield spread is now 260bp.
It is likely to widen. The job of the MPC has been complicated by the UK government?s decision to adopt the EU-harmonized consumer price inflation measure. At a stroke, this lowered the headline inflation rate by one percentage point to 1.3% year on year, well below the 2% target. But the MPC has tightened interest rates by 50bp in response to rising house prices, planned utility price rises and private credit growth.
So far, the Bank of England?s warnings have been ignored. Consumer credit rebounded in January as borrowers increased credit card spending by £1.9 billion ? the biggest monthly rise since last May. And banks and building societies continue to throw credit at prospective house buyers. Expect Bank governor Mervyn King and the MPC to keep up the pressure. The Bank?s repo rate could hit 5.5% by the year-end. There?s simply too much momentum in the UK economy.
Prospects are rosier in the UK than in the rest of the EU. As chancellor of the exchequer Gordon Brown put it, the country has experienced its longest period of sustained real GDP growth for 200 years. That?s partly because of easy money and more government spending.
The chancellor has used low borrowing costs to raise government expenditure ahead of the next election. The debt will have to be paid back eventually and the budget deficit is going to widen.
Ironically, high government spending will not worry currency markets for now ? it fuels demand and increases the UK?s growth differential with the rest of the EU.
Retail sales volumes in the UK have this year grown by an average 6.7% year on year, compared with 3% in 2003. And real GDP growth is likely to be 3% this year.
This year there will be no fiscal tightening. There are more jobs, and wages and bonuses are rising. House prices are on the up, freeing yet more capital for household spending. Real disposable income should grow 4% this year.
By contrast, jobs are still being axed in Germany. France is doing little better. Property prices in core Europe are flat. Disposable income is set to fall again this year. That will permit no more than 0.5% real GDP growth. So the UK’s positive growth differential over the rest of the EU has room to widen. I reckon it could reach 2.5 percentage points this year.
And with the Bank of England planning to raise interest rates, the Federal Reserve on hold and the European Central Bank likely to cut rates soon, sterling cash is getting more attractive.
Sterling is an attractive alternative to dollar debt. High deposit rates and strong economic growth immunize the currency to some degree. Sure, the UK?s external deficit is widening. January?s trade gap of £5.6 billion was the widest ever. But it?s not all bad news. Exports to the rest of the EU have picked up. The economy has grown strongly, so the current account deficit is 3% of GDP. But that?s well below a peak of 5.7% recorded in the late 1980s and a similar-sized deficit expected this year in the US. So the UK deficit is not sufficient to damage confidence in sterling.
Funding through growth paper
Also, the UK current account deficit is being mainly funded by foreigners buying the debt of such financial institutions as insurance companies and investment trusts in the City of London, while the US derives 60% of its capital inflows from foreigners buying treasuries and agency debt. Overseas investors are investing in assets that capture the rising return on UK private-sector capital. That makes the financing of the external deficit much more sustainable than that of the US.
And the old bugbear of UK accession to the EU single currency is off the agenda until at least 2006. In any case, there is little sign that the government could win a referendum on joining the single currency. The latest opinion polls showed that around two-thirds of people surveyed would vote against it. The Eurosceptic electorate will take a lot more convincing from prime minister Tony Blair, whose integrity has already been undermined by setbacks in Iraq.
The one big risk is that the MPC will become over-zealous in raising interest rates and will damage the housing market, sending the UK consumer into a tailspin. But I reckon that would only happen if rates were to reach around 7% from the present 4%, given current levels of household debt and income. I don?t think the MPC will go that far when overall inflation is already down to just 1.1%.
