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Thursday December 2, 2004 - 13:32:08 GMT

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Will Sterling break 2.00

Although attention is currently focussed on US dollar vulnerabilities, the fundamental differences between the US and UK economies are not large enough to justify substantial currency shifts. The UK housing sector imbalances are likely to be an important medium-term factor in curbing Sterling gains. The lack of dollar confidence will underpin Sterling initially and the risks of a slump in the dollar certainly cannot be discounted. Overall, Sterling is likely to peak between 1.95-2.00 this year with a 40% chance of a move above 2.00 in the first quarter of 2005.

Sterling gains sharply

Attention has switched back to Sterling over the past few days with the UK currency making significant gains. The move against the dollar has been particularly marked with a Sterling high of 1.9430 compared with levels around 1.85 in mid November. Sterling has pushed to a 12-year high against the dollar, levels that were last seen before the UKs ejection from the Exchange rate mechanism in September 1992.

Sterling is overvalued

From a purchasing power parity (PPP) perspective Sterling is overvalued at current levels - as any UK shopper in the US will testify. An appropriate level on a PPP basis is probably around 1.30-1.35. The US is, however running a substantial current account deficit and, once the PPP is adjusted to take this into account, a theoretical equilibrium level is likely to be around 1.50. In the long term, this divergence away from fundamentals will tend to cap UK currency gains and eventually weaken Sterling unless there is a sharp rise in US inflation.
This is, however, a theoretical figure and currencies can trade substantially away from their PPP levels for a period of years. The short-term relevance is, therefore, limited.

UK data firm

The economic data for much of November suggested a slowdown in the UK economy with the possibility of a sharp deceleration as the housing sector weakened. The latest data has put this slowdown in doubt. Retail sales figures have been more buoyant and the Nationwide house-price index strengthened by 1.0% in November. The CIPS index for the manufacturing sector also rose to a 4-month high in November. There is still the threat of a medium-term slowdown, but confidence will remain stronger initially.

UK interest rates could still rise.

There had been widespread expectations that the next move in UK interest rates would be for a cut. Markets are, however, now much less confident of this after the recent firm data. The Bank of England is also concerned over longer-term inflation pressures. Given the conflicting pressures, the Bank of England is likely to be content with unchanged rates in the short term.

Dollar weakness in focus

The US currency has been subjected to substantial selling pressure over the past month on fears over the current account deficit and a reserves switch out of the US dollar. There is a risk that dollar selling will intensify and this would push Sterling higher. Given that Sterling still has some status as a reserve currency, there may also be a flow of central bank assets into Sterling. A potentially more important factor is that confidence in the Euro-zone economy will be fragile. While Asian central banks also prevent currency gains, Sterling may be seen as a more attractive vehicle to sell dollars against and this will increase the appreciation potential. This is particularly significant as the Bank of England appeared comfortable with Sterling strength in recent comments.

UK also in deficit

The UK is also running significant budget and current account deficits which will test investor support for Sterling. The deficits, at 2-3% of GDP are not on the scale of the US deficits. There is, however, still the risk of capital flight from the UK if the deficits continue to rise. The recent export performance has remained generally weak.

Housing market crucial

As well as being overvalued, Sterling will still face hurdles to further significant gains. The short-term interest rate gap between dollars and Sterling is likely to narrow as the Fed continues to raise rates. This will tend to reduce capital inflows into Sterling. The overheated housing market is still a major medium-term threat to Sterling as an sharp adjustment in prices would put serious stresses on the UK economy. In addition, political risks will increase ahead of a probable May 2005 election.


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