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Wednesday January 5, 2005 - 15:38:48 GMT

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Sterling vulnerable in 2005

Sterling is likely to face tougher challenges in 2005. Interest rates will peak during the year, even if they have already not done so, and this would risk an exodus of short-term funds from the UK, especially with US rates rising. The widening current and budget deficits will also test investor confidence. A housing-sector collapse should be avoided, but there is a high risk that prices will gradually fall and this will undermine Sterling confidence. Overall, trade-weighted depreciation of at least 4% is likely with a 10-20% risk that depreciation will exceed 10% during 2005.

Uncertainty over UK interest rates.

There has been widespread expectations that the next move in UK interest rates will be a cut. This speculation was reinforced by the December Bank of England minutes which indicated a view among some members that a cut might be possible in the first quarter of 2005. Headline inflation has remained comfortably under the 2.0% target, despite a November increase to 1.5%, but there has been a worrying increase in earnings growth. Given the conflicting pressures, the Bank of England is likely to be content with unchanged rates in the short term. The bank will certainly be cautious over cutting rates. Indeed, if inflation starts to rise, the bank will have to consider higher interest rates or delay a cut even if the housing market is weakening.

Housing market will be crucial

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 wider UK economy. Consumer borrowing has been fuelled by rising property prices and any downturn would force a cut in borrowing and spending levels. There has been further evidence that the housing market is slowing and this trend is likely to continue during 2005, although the pace is in doubt. There has also been greater speculation that the slowdown is having an impact on wider consumer spending trends. If this is confirmed, Sterling sentiment could weaken sharply. There will be fears over an emergence of a self- reinforcing downward cycle. Weaker growth, for example, would increase fears over the budget deficit, undermine Sterling, prevent rate cuts and reinforce downward trends in the housing market which would further damage growth.

UK also in deficit

Although attention has focussed on the US twin deficits, the UK is also running significant budget and current account deficits which will test investor support for Sterling. The third-quarter current account deficit, for example, increased to GBP8.77bn. The 2005 deficits are likely to be around 3.5% of GDP for 2005 and are not yet on the scale of the US deficits (the US current account deficit is above 5% of GDP). There is, however, still the risk of capital flight from the UK if the deficits continue to rise, especially as investors will not be as tolerant of UK deficits as they have been over US deficits.

Currency is overvalued

From a purchasing power parity (PPP) perspective Sterling is overvalued at current levels - as any UK shopper in the US will testify. A theoretical equilibrium rate for the UK is probably around 1.50-1.60 against the US dollar and around 0.75 against the Euro. In the long term, the divergence away from fundamentals will eventually weaken Sterling unless there is a sharp rise in inflation outside the UK.

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, still limited.


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