Global Insight Perspective

Significance

The pound first neared the psychologically important US$2.00 barrier in January, but it needed the prospect of a further rise in U.K. interest rates to finally send it above this level.

Implications

There will be both winners and losers as a result of the strength of the pound. Consumers should largely benefit, but it could cause significant problems for U.K. exporters in particular.

Outlook

We suspect that sterling could stay above US$2.00 for an extended period.

The pound traded above US$2.00 yesterday for the first time since it was forced out of the European Exchange Rate Mechanism (ERM) in September 1992. Sterling has since edged up further to trade just above US$2.01, which is its highest level since June 1981.

The pound had first neared the US$2.00 barrier back in January, when the Bank of England unexpectedly raised its key interest rate from 5.00% to 5.25%, but it had been unable to build on these gains. The catalyst finally sending sterling above US$2.00 yesterday was news of a sharp rise in U.K. consumer price inflation to 3.1% in March. This not only cemented expectations that the Bank of England will raise interest rates by a further 25 basis points to 5.50% at its May policy meeting, but also boosted market speculation that U.K. interest rates will rise further thereafter.

Combination of Sterling Strength and Dollar Weakness

Sterling's rise above US$2.00 is a consequence of both sterling strength and dollar weakness. Although there is no denying that the pound is strong overall, it is also notable that the dollar is currently trading at a two-year low against the euro (US$1.36:1 euro). Significantly, the dollar is currently trading only marginally above the lowest point (US$1.367:1 euro in December 2004) it has hit against the euro since the Eurozone came into being in 1999. Furthermore, the dollar has weakened to long-term lows against several other currencies, notably the high-yielding New Zealand (a 22-year low) and Australian (a 17-year low) dollars.

Indeed, the pound is actually modestly softer overall at the moment than it was in January. Specifically, sterling achieved a 16-year high of 106.6 on its trade-weighted index (TWI) in January, when it traded at a two-and-a-half-year high of £0.6537:1 euro (1.530 euro:£1), as well as reaching a then peak of US$1.9914:£1. Despite moving above US$2.00 yesterday, the pound is currently trading below its January peaks at around £0.675:1 euro (1.480 euro:£1) and 104.3 on its TWI.

The prospect of the pound reaching US$2.00 had been on the cards for several months. Indeed, we included it in our top 10 U.K. predictions for 2007 at the end of 2006. Specifically, we wrote then, "The pound will trade above US$2.00 in 2007. We expect the dollar to come under significant widespread downward pressure during 2007 from softer U.S. growth, the Fed trimming U.S. interest rates in the second half, the massive U.S. current account, and limited diversification of foreign-exchange reserves by some central banks. Indeed, we see the euro trending up to US$1.40:1 euro. The dollar's weakness is expected to lead to sterling trading above US$2.00 for an extended period in 2007, although we forecast the pound to lose some ground against the euro."

Outlook and Implications

We believe that sterling could well remain above US$2.00 for an extended period. In the near term, the pound is likely to be supported by expectations of higher U.K. interest rates. Although we currently forecast that U.K. interest rates will peak at 5.50%, there is clearly a markedly increased possibility now that they will reach 5.75%, or even 6.00%. Meanwhile, we expect the dollar to be pressurised by the factors outlined above. We believe that U.S. interest rates have peaked at their current level of 5.25% and will be trimmed to 5.00% later this year. As a result, interest-rate differentials will move in sterling's favour.

There will be both winners and losers as a result of this development. The most obvious winners will be U.K. tourists going to the United States and other dollar-linked destinations. Shopping breaks to New York and other U.S. cities will seem particularly attractive. The flip side is that the United Kingdom will be a more expensive destination for U.S. tourists and shoppers (although as the dollar is also weak against the euro, the United Kingdom will be no more expensive than much of Europe). Meanwhile, U.K. consumers should benefit from cheaper prices for some imported goods.

U.K. exporters to the United States will obviously find their competitiveness impaired, and they will also be at a disadvantage against U.S. and dollar-linked exporters in third-country markets. In addition, U.K. companies will find their competitiveness weakened against imports from the United States and other dollar-linked countries. However, there is good news for U.K. companies as well. Given that oil, metals and many raw material prices are typically quoted in dollars, the strength of the pound against the dollar should dampen firms' input costs. Firms will also find it cheaper to invest in the United States.

Also through holding down the price of imported goods and raw materials, the strength of the pound may limit the need for interest rates to be raised markedly, although a rate hike to 5.50% in May now looks certain.

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