Did you know that if you had bought the pound back in 2009 when it was trading at a mere $1.35, your investment would have appreciated to the tune of 20 per cent?
Not a bad return in this environment, but what has driven the pound higher versus the dollar and will it continue its climb?
The pound has had a two-phase recovery since the financial crisis. The first phase was from 2009 until mid-2013, when sterling traded against the dollar from a low of $1.35 to a high of $1.70 in August 2009 before settling in a range of $1.50–$1.65. During this period the UK was one of the last of the developed economies to exit recession and we had a few false starts with our double-dip recession in early 2012.
It was not the UK economy that was firing this recovery in the pound; it was what the foreign exchange market would call a technical recovery. The pound had been sold so sharply in 2008 and 2009 that it started to look cheap and that is when it started to excite investors. From 2007 speculators had started to ditch the pound aggressively, according to the US Commodity Futures Trading Commission, which measures speculative activity in the forex market. Three years of net selling reached a nadir in the first quarter of 2010, when investors started to come back and see the pound as oversold and thus deserving of their attention.
The second phase of the recovery happened in 2010. Back then the UK’s economic fundamentals were far from lustrous, although the country was looking like a shining star compared with its neighbours in Europe, where the eurozone sovereign debt crisis was unfolding.
Investors started to see the pound as a safe haven alternative to the euro, and during the eye of the sovereign storm between 2010 and mid-2012 the euro fell nearly 15 per cent against sterling.
Thus, the pound was able to get away with patchy growth and flirting with a double-dip recession, simply because the UK was not in the eurozone.
Largesse
A pillar of the forex market is central banks, and the Bank of England has also fuelled the pound’s recovery against the dollar. Following the financial crisis central banks went into largesse mode and both the US Federal Reserve and the BoE embarked on quantitative easing. However, there was a key difference: the UK’s QE was mere pocket money compared with the Fed’s trillion-dollar splurge.
While the BoE has spent £375bn on QE, the Fed has printed trillions of dollars – and is likely to continue printing money throughout 2014.
The relationship between foreign exchange and central bank balance sheets is not perfect, but currencies tend to weaken when balance sheets expand and vice-versa.
This is down to simple economics – there is more supply of a currency in circulation, so its value falls.
Hence, compared with the Fed, the BoE has been downright restrained, which has helped sterling to recover against the dollar.
There is another thing to consider when it comes to central banks: the market’s trust in the bank, particularly the governor. There is evidence to suggest the Fed has been more successful at this than the BoE. The market ignored BoE governor Mark Carney’s dovish call to arms when he announced the introduction of forward guidance back in August 2013.
Mr Carney’s timing was slightly off; the economy had started to gain traction and was growing at a rapid clip – hence the market did not believe the BoE would keep rates on hold for another three years. They decided to call the BoE’s bluff, pushing sterling higher versus the dollar by more than 10 per cent in the second half of 2013 and sending gilt yields higher to the tune of 120 basis points.
The BoE, and Mr Carney, in particular, were punished by the market, which did not see their actions tallying with the reality on the ground. The economy was stronger than the BoE’s forward guidance suggested, and the market was not going to wait for the BoE when it believed the Bank was behind the curve.
Shadow
Indeed, the market has been proven correct and in recent months the BoE has followed the market’s lead and adjusted forward guidance to reflect the upbeat tone in the UK economy.
While the market may treat the BoE with disdain, it seems to have a higher regard for the Fed. The Fed has been accused of trying to manipulate its currency lower, and you could argue that the market has granted the Fed its wish. Since reaching a peak in 2009 the dollar has fallen by nearly 10 per cent in the past five years.
So does the market treat the Fed with more reverence than the BoE? One could argue it does, and September’s shock Federal Open Markets Committee decision is a case in point.
Back in autumn last year we were all waiting patiently to hear the FOMC announce it was going to start tapering its asset purchases. We analysts had done our homework, jobs data was trending higher and the US economy was creating nearly 200,000 jobs a month on average. The rest of the economy looked fairly solid too, so surely it had to stop buying assets at some stage?
No. The Fed back-tracked, saying the economy was not strong enough and QE would continue as before. The outcome of this was that the Fed (allegedly) got more of what it wanted: the dollar fell some 5 per cent between September and October last year, which corresponded with further pound strength.
So what lies in store for sterling in 2014? Now that the Fed has embarked on tapering it may be difficult for the dollar to wallow in the doldrums like it has done in recent years. In contrast, after such a positive second half of 2013, the pound could come off the boil. After all, the economic data has started to cool a bit and the market may start to see the BoE’s dovish stance as justified.
If the market starts trusting the BoE’s judgment, that could be the time to reconsider those long sterling positions.
Kathleen Brooks is research director of Forex.com
Key points
The pound has been through a two-phase recovery since the financial crisis
The Bank of England has also fuelled the pound’s recovery against the dollar
The US Federal Reserve has been accused of trying to manipulate its currency lower, and it could be argued the market has granted the Fed its wish
