Commentary: Pound sterling's visit above $2 may not last long

While the sterling/euro exchange rate, which has been relatively stable of late, is the key one for the majority of exporters, the sterling/dollar rate remains highly significant.

By PETER DIXON, MARKETWATCH
pound sterling 88 (photo credit: )
pound sterling 88
(photo credit: )
MarketWatch: In-depth global business coverage With the pound having breached the psychologically important $2 level, the cable rate is now at its highest since 1981. This may be great news for tourists planning a shopping spree in New York but it is less good news for exporters. Although 57% of UK exports go to the EU, this still leaves another 43% going to non-EU countries. So while the sterling/euro exchange rate, which has been relatively stable of late, is the key one for the majority of exporters, the sterling/dollar rate remains highly significant. But what has driven the pound up so far? Sterling is considered as a high yielding currency on the markets, and with interest rates set to rise further in the wake of above-target inflation, investor interest in sterling is likely to remain strong - especially if it can be financed via carry trades using low cost currencies such as Japanese yen or Swiss francs. There has also been renewed interest in sterling from official sources. At the end of 2006, emerging economies held almost 6% of their reserves in sterling, versus 3.5% in 2002. And with these economies increasing their reserve levels at a rapid rate in absolute terms, a rising share implies a considerable increase in demand for pounds. The implications of a strong pound will be felt especially keenly in the manufacturing sector. A measure of the market's concern is provided by trends in key equity sectors. One of the worst performers in recent weeks has been the automobiles and parts sector of the FTSE All-Shares index, which is down 1.5% over the last month. Another potential issue which is raised by a rapidly rising pound is the impact which it may have on foreign investment in the UK market. In 2006, the value of net foreign acquisitions of UK companies amounted to 75.5 billion - way ahead of the previous peak of 64.6b. registered in 2000. This is a clear indication of the extent to which M&A activity has been a key driver of market activity, and highlights that if sterling were to rise too far, too quickly, it would reduce the attractiveness of UK companies to foreign investors. Foreign interest in the UK is less to do with the attractiveness of sterling denominated assets per se, so much as it is part of the ongoing boom in M&A activity. But fears that a stronger pound could take the edge off demand for UK companies would soon spread to affect the value of UK equities as well. Corporate profitability would also likely suffer as a consequence of a rising pound. According to official ONS figures, the net rate of return on capital employed in the manufacturing sector in 2006 averaged just 8.5% - the lowest since 1992, and well below the 19.7% rate enjoyed in the services sector. At a time when the sector is finally beginning to reap the reward of a recovery in the euro zone, the last thing beleaguered manufacturers need right now is a further squeeze on profitability. So how much do we really have to worry about a rising pound? With the interest differential between the UK and Japan/Switzerland likely to remain substantial over the coming months, carry trade activity will also remain buoyant. Expectations of US rate cuts later this year may also put upward pressure on the pound. But to some degree, expectations of sharp hikes in UK rates might be misplaced. After all, inflation will decline over coming months, partly due to big cuts in utility bills, and the situation will look much more favorable in six months' time. Moreover, the cause of US rate cut expectations is the likelihood that the economy will continue to remain sluggish over the coming months. The UK will not escape such an event unscathed, and it is even possible that we will be discussing the need for UK rate cuts in six-nine months time. Consequently, we should not expect the sterling/dollar rate to continue rising much above $2. Nor do we expect it to remain above this level for long. So while it may be appropriate to express concerns about what a strong pound might do to the markets and economy, our best guess (for currency forecasting is an inexact science) is that we are more likely to be back at $1.90 on a six-month horizon than to see sterling make further gains to $2.10. The author is UK economist at Commerzbank AG. MarketWatch: In-depth global business coverage