The Hindu Business Line : Sterling continues to enjoy sunny days

Bank of England has already started the cycle of tightening interest rates and the next hike may not be far away. Federal Reserve and European Central Bank are still considerable period away from any hike. This gives UK a clear yield advantage; some part of the sterling strength is due to carry trades in search of better yields.

IN hey days of the British Empire, the Empire stretched from one part of the world to the other. This meant that the sun never set in the empire. The power of Britain was unparallelled and sterling was undoubtedly the primary currency of world trade.

After the world wars US and Japan became the new centres of growth. Greenback emerged as a preferred currency for trade. Bank of England tried hard to keep the sterling strong even though the economic fundamentals did not support it. This led to the ERM crisis with speculators taking on the Bank of England and eventually breaking the band.

Sterling collapsed and broke below the mark of two to a dollar. Since the early 1990s sterling has primarily remained in the band of 2-1.40 against the dollar.

Most of the pundits believe that the fair value of sterling is around 1.6000 against dollar. If you would talk to any seasoned cable (sterling against dollar) trader, you would have heard one their commandments- "thou shall buy cable only to take profit".

Most of the traders loved to trade the cable being short; such was the confidence in the inherent strength of sterling. Over the past couple of years the strength of sterling has been attributed to the fundamental weakness of dollar. Sterling has found unusual strength over the past few months against dollar and touched 1.8500.

So what is causing this incredible strength of sterling against dollar? One of the factors is the high UK yields. As amazing that it may sound, low trend rate of growth of UK economy is resulting in higher interest rates!

If one compares the trend rate of growth of US to that of Britain, Britain is almost a per cent lower. US trend rate of growth is 3.5 per cent whereas for Britain the similar figure is 2.5 per cent.

As the global economy went into a downturn, Bank of England also lowered the interest rates to protect its economy from cross-border transmission of slowdown. Low interest rates have led to sharp growth in housing sector.

Although UK did slow down, it never went into a quarter of negative growth like US. The Monetary Policy committee has been looking at target inflation over a two-year period. Though the benchmark used to look at inflation has been changed, a lower trend rate of growth implies that a lower rate of UK growth can trigger inflation pressure than it does in US.

This results in UK monetary authorities becoming less tolerant of higher growth than Federal Reserve. Bank of England has already started the cycle of tightening interest rates and the next hike may not be far away. Federal Reserve and European Central Bank are still considerable period away from any hike. This gives UK a clear yield advantage; some part of the sterling strength is due to carry trades in search of better yields.

Another important factor that could affect sterling in the future is how the British trade, exports in particular, is affected by this strength. Over the past year UK has become more competitive against economies that show few signs of pick-up in domestic demand such as the Euro zone nations and less competitive against economies that are showing signs of domestic demand recovery such as US and Asia.

Since January 2003 sterling has appreciated around 17 per cent against dollar-denominated economies and depreciated 8 per cent against euro. This means that sterling strength on trade-weighted terms has not made a significant dent. This should remain the same till sterling rallies against euro.

Strength of sterling this year would depend on whether investors can earn superior returns by holding US or UK assets. US growth is likely to exceed UK's growth by around one per cent in the long run. Low wage growth in US would result in higher corporate profit growth.

However, a large part of this expectation is already priced in the equity market as US market has a higher price to earning ratio than UK equity market. This would deter UK investors from investing in US equities. Investors would also be cautious after the beating they took on their US investments in 1999- 2000.

Strength of sterling in the last few weeks has sent pound to levels that exceed normal relationships with yield spreads. This move looks vulnerable to correction and any rise in US interest rates from here would put pressure on carry trade.

If the chances of any Fed hike recede, then sterling would enjoy this strength for some more time. Old advocates of sterling can enjoy this new- found strength for some time to come!

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)