Some sterling buzz

Two weeks ago, there was a news item in the London Telegraph that the Bank of Italy had been shifting reserves from USD to GBP.

The share of Sterling in their foreign exchange reserves went from 0% in 2004 to 24% in 2005. Please note that this has been done. It is not to be done in the future. The article goes on to describe the Russian decision to reduce USD holdings of its reserves to 40%. However, the article failed to mention that the Swiss National Bank did something similar. It increased its sterling share from 6% to 10% in 2004. In general, it increased its share of other currencies to 24% in 2004 from 13% in 2003 while the share of the US dollar and the Euro was reduced.

All this is in keeping with the current bearish and pessimistic talk on the US dollar.

Right now, there is some optimism that the UK has a very balanced economy. It is not overheating cyclically. Inflation appears to be under control. The housing market has already come off the boil.

Much of the recent pessimism on the US dollar stems from the focus solely on the prospect of future rate increases. Futures contracts on USD interest rates do not show even 5.5% by year-end for the Federal Funds rate.

The GBP/USD exchange rate and the future interest rate differential between the US and Britain show a good correlation. In recent times, markets have ratcheted up their expectation of interest rates in the UK while simultaneously they have pared back their expectation of rates in the US. The Bank of England surprised markets with a rate hike two weeks ago. The official rate in England stands at 4.75%. Justification for the rate hike came in the quarterly inflation report released by the Bank of England a week after its rate hike. The bank expects inflation to be much higher than its target in the next two years. It wanted to pre-empty that. The market believes that it would surely be at 5.0% by the year-end. There is speculation about the rate reaching 5.25%.

Like the Beige Book in the United States that the Federal Reserve releases two weeks before it meets for deciding on interest rates, the UK has its own beige book. Only that, it is titled somewhat strangely as ?Agents? survey of business conditions?. Interested readers can find it on the web site of the Bank of England. This survey is released on a monthly basis. It points to a strong rebound in retail sales and the increasing ability of manufacturers to pass on their costs to end-users. Clearly, the UK economy in 2006 is a different animal than it was in 2005.

In contrast, recent data?surprisingly low inflation and weak consumer confidence?have led market participants to believe that the US Federal Reserve has all but ended the cycle of rate increases that began in 2004. The talk is on when they would begin to cut rates. Such talk may be premature. Retail sales in July grew strongly and the manufacturing index of the Philadelphia region has rebounded strongly in August from the July dip.

Indeed, there is an alternate scenario to the one embraced by markets, neatly expounded in a note by HSBC, that the Fed is forced by near-term economic strength to hike further up to 6.0% or so.

This view is not as outlandish as it might appear, at first glance. Historically, the Fed begins to lower rates only when the nominal GDP growth rate begins to turn down. In this cycle, nominal GDP growth is still going strong at well over 6.5%. The federal funds rate is at 5.25%. Such a big gap means that the cost of funding is lower than the rate at which national income is growing. Cost of long-term loans is even lower. In other words, the level of interest rate is supportive of growth and not restrictive.

With the price of crude oil retreating too, it should not be a surprise if US growth rebounds in the third and the fourth quarter after a lull in quarter two. Hence, one might see the return of the chatter of the Federal funds rate going up to 6.0% soon. At the turn of this year, not many expected central banks in the UK and in Australia to hike interest rates. Not only have they done so once, there is talk of them doing it once or even twice more.

Of course, higher rates would raise the risk of a hard landing in the US economy next year. But, that is a story for the next year and it should be noted that it is a risk and not a central scenario. Corporations in the US are sitting on fatter profits and wages in the US are growing slowly than in previous cycles. OECD economist Helmut Reisen estimates that the global labour force doubled from 1,460 million to 2,930 million after 2000.

Therefore, if the HSBC view begins to be accepted by markets (that would depend on data in the coming weeks), then the outcome would be a sudden and sharp jump in the USD against most currencies.

Hence, while one applauds the unbroken string of economic growth in the UK for fourteen years (the last negative quarterly growth was recorded in June 1992) and the soft landing in their overheated housing sector, it is unlikely that the pound sterling exchange rate against the US dollar goes to 2.0 USD for one unit of the British pound. The question is when the market finally accepts that the US economy and the US dollar have been trashed too harshly and for too long.

?The writer is head of research, Asia-Pacific and Middle East, Bank Julius Baer, Singapore. These are his personal views. He can be contacted at jeevatma@gmail.com