Despite the gloom that currently surrounds the UK’s economic outlook, the pound sterling has performed strongly, up around 23 per cent (as at July 14 2023) versus the US dollar since September 2022, and 5 per cent relative to the euro.
Economic textbooks theorise that the principal determinant of the relative strength of one currency to another is trade flows — that is, the level of goods one country exports to another.
An economy that exports more to another than it imports would, all things being equal, expect its currency to strengthen relative to that of the country with which it has the surplus. Such a surplus is known as a current account surplus.
The UK has, however, run a current account deficit — importing more than it exports — with the rest of the world, and with the US, for a prolonged period of time.
The second iteration of this, and the basis upon which currency traders operate, is to attempt to understand the economic data and from that predict what might be the position of a country’s current account. This means in normal circumstances currencies rise when the economy to which they are tied performs well.
The UK economy is performing better than some peers, for example, Germany, but not relative to the US, where growth remains robust.
So why has sterling done so well?
George Lagarias, chief economist at Mazars Wealth, says that in reality, the biggest influence on the performance of one currency relative to another is interest rate expectations.
He says that higher interest rates push up the value of a currency because those who own assets in that currency will be paid a higher rate of interest than those who own assets in a currency that is not raising rates.
This can be seen in the context of UK gilt yields rising sharply in recent months as investors revised their expectations for the base rate.
The most recent inflation data in the US showed a decline to 3 per cent, while in the UK inflation remains at about 8 per cent.
Rates of change
It is this that has prompted investors to buy sterling relative to the dollar in recent months, as they anticipate the pace of US interest rate rises will decline relative to the pace of those in the UK, Lagarias says.
He notes that sterling is up by only around 5 per cent against the euro since September 2022, something he attributes to the market anticipating that rates will also have to rise in the eurozone at a pace greater than that of the US.
Data from consultancy Longview Economics shows the number of professional investors who are “net long” the pound — that is, who profit if sterling keeps rising — is at its highest level for 10 years.
IG Group chief market strategist Chris Beauchamp says: “[This is] mostly rate differentials, I would say, in that US inflation keeps falling while UK [inflation] remains strong.
