Has 'stable' sterling fallen too far?

Sterling has fallen sharply over the past six months, mostly against other European currencies and the yen, but it has even fallen against the weak dollar. On a trade weighted basis, sterling is down about 10 per cent, an unusually large move compared with those seen over the previous 10 years.

However, the move lower has come after a long period of relative stability for sterling (1997-2007) and has taken it back down only to a level just below the average seen between 1990 and 2008. It is difficult to argue that sterling is except-ionally 'cheap'.

The recent sharp moves in sterling are unusual in that they have been accompanied by changes in the relative UK interest rates. Looking at a simple sterling index (50 per cent euro, 50 per cent US dollar) and a similarly weighted two-year interest rate swap spread, we note that for much of 2006 and 2007, sterling moved with the interest rate spread. The rising spread from June 2006 to September 2007 was associated with a move higher in sterling, and the narrowing spread from then to the end of 2007 was associated with a fall in sterling.

Since the beginning of the year, however, the interest rate spread has widened and yet sterling has fallen sharply. Historically, a rising interest rate premium would see sterling rise. However, the impact of the wider spread this time has been dominated by concerns about the reasons why the spread has been widening.

Although the markets see the UK and US economic situation as having many similarities, the Monetary Policy Committee has not been as aggressive as the Federal Reserve Bank in cutting rates in response to housing market weakness and the growing risk of credit contraction. This has been because of the fears in the UK over rising inflationary expectations. In addition, money market rates in the UK continue to trade at a significant premium to official rates, which is seen as a sign of continuing concern over the health of the banking system.

We look for the base rate to fall to four per cent by year-end, and then just 3.5 per cent by mid-2009, as overall GDP growth slows to a roughly one per cent pace over the coming two years. This prospect is likely to be a drag on sterling going forward, even in an environ-ment where relative interest rates are less of a driving force for the currency.

One seemingly positive development for sterling has been the sharp narrowing of the current account deficit seen in the latest release. The current account deficit in the fourth quarter of 2007 narrowed sharply from 5.5 per cent of GDP to just 2.4 per cent. Does this mean that the weaker pound is helping re-balance the economy by stimulating exports? Unfortunately not, as all of the improvement in the current account in the fourth quarter was due to an increase in net overseas investment income, rather than to an improvement in trade.

However, the biggest continuing threat to sterling probably comes from the direct investment account. At the end of 2006, an important reason for sterling strength at the time was the scale of the direct investment inflows that came from the boom in cross-border Mergers & Acquisitions activity. Official data on direct investment is only available up to the third quarter of 2007, but these show that the big inflows seen in 2005 and 2006 had already faded by then. One of the consequences of the credit crunch has been to reduce the global volume of M&A activity. In the last six months, volume has more than halved and there seems little prospect of a recovery over the next few months.

With regard to the trade sector, the balance of trade in goods has continued to deteriorate and now stands at 6.6 per cent GDP. It is possible that the fall in sterling will improve the trade position, but the evidence from 1992 is not encouraging. Following the large fall in sterling after its ejection from the Exchange Rate Mechanism, UK exporters chose to increase prices and profit margins rather than increase volumes, and the trade deficit in 1993 actually widened.

Although sterling has fallen sharply over the past six months, the risks for the currency still appear to be to the downside. Sterling has not yet fallen to levels that can be considered 'cheap' and higher relative UK interest rates are more a sign of weakness than of strength. The improvement in the UK current account position has only been seen because of write-downs on UK assets owned abroad, and does not reflect an improved underlying position. Perhaps most worryingly, the strong direct investment inflow into the UK that was such an important support for sterling during 2005-2007 is now going into reverse.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.