Michael Baxter

Pound falls to three year low against dollar

Written by: Michael Baxter on July 8th 2013

Category: Thought for the day

The signs of recovery are becoming clearer, as today’s bull and bear tells. There are even suggestions that the UK may enter a period  of… well, of boom. But there is one threat, one way in which triumph could turn to despair. Today I focus on that.

As I write these words there are just 1.4881 dollars to the pound, which means that the pound is currently at its cheapest level relative to the dollar since June 2010. Okay, sterling has been cheaper before. For a short period in early 2009, there were fewer than 1.40 dollars to the pound. In the mid-1980s sterling fell so sharply that at one point parity with the dollar seemed like a distinct possibility. Indeed, right now, the UK dollar exchange rate is quite favourable for the UK, and certainly may provide impetus for an export led recovery. But it’s the trend that worries me, and it is the possibility that sterling may fall much further that worries me even more.

Then again, this is not a problem which is unique to the UK. The dollar is strengthening relative to currencies across the world. You don’t need to look far for an explanation. As the Fed talks about tightening monetary policy, of slowly beginning to reduce the extent of its quantitative easing programme, and suggests interest rates may rise in the year after next, markets begin to price in the implications.

Higher rates in the US mean that money flows into the US economy, pushing upwards on the dollar. The yield on US treasuries has risen very sharply. The yield on ten years is up from less than 1.7 per cent in April, to 2.69 per cent at the time of writing. And indeed, the yield on ten year treasuries right now is at a 22 month high. While the yield on the UK equivalent has risen too – up to an 18 month high – the rises lag well behind what we have seen in the US. At the time of writing, the yield on UK ten year government bonds is 2.48.

So far the story is benign. The US economy does appear to be enjoying a proper recovery now, and US consumers are in the best shape they have been for a long time. At the same time the pound is cheaper to the dollar. So that’s all good for those exporters who sell a high proportion of their wares to the US. The yields on UK bonds remains modest, despite rises in yields on US bonds, so that is good for the cost of repaying government debt.

The Bank of England and the ECB have emphasised that their monetary policy is not dictated by the US Federal Reserve. Last week both banks suggested that they have no plans to tighten monetary policy for the foreseeable future.

The rise, however, lies with the possibility that the US recovery will gather momentum, while the UK and Eurozone economies don’t. Let’s imagine it is 2016, and US interest rates are back to say four or five per cent. Under such circumstances the Bank of England will surely have no choice but to up rates, or else there is a danger that sterling will crash out of sight, creating a new inflation threat. But we may not have to wait until then. The markets may anticipate this, and sterling may come under pressure next year.

One of the main differences between the UK and US economies right now is that both US household debt and US house prices are much lower to household income. A recent report from the Bank of England indicated that if UK interest rates were to rise by 2 percentage points, households representing 20 per cent of all mortgage debt would be unable to pay their mortgages without taking drastic action – such as working more overtime or cutting overheads.

Right now the UK economy cannot afford rising interest rates. For this reason, the Bank of England has said rates are not likely to rise for some time. But the US economic cycle is not in sync with the UK cycle, and as rates rise across the pond, sterling may come under more pressure. The worst case scenario is that the Bank of England will have no choice but to tighten monetary policy, even though UK households can ill afford higher rates.

Don’t misunderstand me, I do not sign up to the school of thought that sees nothing but doom for the UK economy. I am merely focusing on the downside in this particular article. And the downside is simply this:  the fact that in the US household debt and house prices are much lower than in the UK may yet prove telling, especially if the Bank of England has to up rates to avoid a rout on sterling.

These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Tags: pound to dollar, US UK interest rates, when will UK rates rise

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