The stronger pound will curb inflation, says Hamish McRae

Up to $1.40? When I wrote earlier this year that the pound was grossly undervalued and that this was my target for sterling, I felt I was sticking my neck out.

Well, we are now through $1.30 and hedge funds and other currency speculators believe it will continue to rise.

Bullish bets on sterling are at a nine-year high. It’s a far cry from the manure the professional investors were heaping on the poor old pound a year ago, and a welcome change of mood too.

Most commodities are priced in dollars, so a stronger sterling/dollar exchange rate translates directly into lower import costs, which will eventually put pressure on retail prices, including fuel at the pump.

But while the gradual restoration of confidence in the pound sterling is worth celebrating, we shouldn’t get carried away. This is primarily a dollar issue, as the US currency seems to be losing its safe haven appeal, and almost all other currencies have risen against it.

The pound has recovered slightly against the euro and is at a 10-month high of €1.17. Given that the UK economy seems to be growing a bit, and certainly doing better than most commentators expected, while the Eurozone was in recession, this makes sense.

But sterling is only in the middle of its five-year trading range against the euro, so there’s no real recovery in confidence – just a retreat from last autumn’s absurdly excessive gloom.

There is also the clear concern that applies to all currency movements that the British pound’s recovery is being driven by short-term investors chasing higher interest rates.

One of the reasons for the dollar’s fall is the perception that the Federal Reserve will soon be able to start cutting rates given the slowdown in the economy and evidence that inflation is being tamed.

The general rate fell to 3 percent in June. There may be one or two more Fed hikes, but the turning point is in sight.

Hamish McRae: Markets seem convinced UK rates have a long way to go to rise

Markets, on the other hand, seem convinced that UK interest rates have a long way to go to rise.

An extreme forecast comes from Schroders, who now thinks Bank of England rates will peak at 6.5 per cent by the end of this year, 1.5 percentage points higher than the current rate of 5 per cent.

If you really want a horror story, Adam Posen, head of the Peterson Institute in Washington DC and a former member of the Bank’s monetary policy committee, told Bloomberg last week that he wouldn’t rule out the Bank going to 7 percent.

I think this is crazy, and that the fall in UK inflation will accelerate in the coming weeks. But at least to some extent the pound’s rise is being driven by hot money, and the speculators can get their money out as quickly as they put it in.

What would really lead to a sustainable recovery in the pound would be a sustainable recovery in exports. Here the story was disappointing, at least as far as physical trade is concerned.

The underlying volume of goods exports is down more than 10 percent from pre-Brexit 2018 levels, and the pandemic has impacted the numbers.

Our physical trade deficit has long been offset by a trade surplus in services. Keep that in mind and while there is still an underlying current account deficit, it fell to 2.6 percent of GDP in the first quarter of this year.

That is an acceptable level, but it is still a shortfall that must be compensated by capital inflows.

We can hope that these are real investments by foreign companies and not speculative money that tries to take advantage of high interest rates.

So what’s next for the pound? My guess is that it will continue to rise against the dollar and at some point will not just return to $1.40, but be quite a bit higher.

Against the euro, a lot depends on the progress of the eurozone economy, and the big question here is what will happen to Germany.

The Ifo Institute, the most respected of Germany’s independent forecasters, now thinks their economy will shrink by 0.4 percent this year, though it expects the eurozone as a whole to show some growth.

Expect the pound to rise a little more against the euro, but I think the gain against the dollar will be more notable.

So plan a holiday in America next year instead of Europe? Not a bad idea from a currency point of view.

But what is far more important to all of us is that the stronger pound feeds through to lower prices, and fast.