We believe pound won't fall just yet

May 9 2007 By Andrew Miller, The Journal

Since the middle of April, the pound in your pocket has been worth more than $2. Sterling hasn't been this strong against the dollar since 1981.

This is great news for British tourists, who can pick up a new iPod for £120 in New York instead of paying £170 here. It's less good for British firms, whose goods are more expensive in the US market.

The question now on everyone's mind is how long the two-for-one offer on the dollar will last.

In the past, the pound has struggled to stay this strong for long. Sterling has climbed to the $2 mark only twice in 26 years. Both times, the exchange rate weakened sharply soon afterwards.

After reaching a dizzying $2.44 in 1980, sterling was back tracking the dollar almost one-for-one by 1985, buying just $1.05. And the last time it was at the $2 mark, in 1992, the pound fell to just $1.41 the following year.

This time around, sterling has risen thanks to interest-rate speculation on both sides of the Atlantic.

"Carry trade" investors have been borrowing dollars and buying pounds. These investors hope that the difference between rising interest rates in the UK and falling interest rates in the US will make them a profit.

As a result, there has been strong demand for sterling, pushing up the price.

The pound has also been strengthened by central banks buying sterling for their reserves. After 10 years of low inflation in the UK, banks see the pound as a safe bet.

Other factors in the pound's rise to fame have been record levels of mergers and acquisitions activity in the UK and the strength of the British property market. The key question now is whether interest rates will behave in the way the carry-trade investors expect. If interest rates carry on rising in the UK and falling in the US, then the pound should stay at $2 for a while.

But if not, we could see the exchange rate fall - probably not as sharply as in the past, but fall nonetheless. And without support from interest rates, sterling suddenly looks very expensive indeed.

In the UK, the market expects interest rates to rise twice more before the end of the year. This is because it thinks the Bank of England will need to crack down on spiralling inflation.

Indeed, at 3.1%, UK consumer-price inflation is now the highest for 10 years.

But our view on the UK is different. We think inflation will ease in the months ahead and don't think interest rates will go above 5.5%.

Similarly, in the US, there has been a lot of bad news on the housing market lately. As a result, the markets expect the Federal Reserve to cut interest rates.

Again, we disagree. We think the housing market is stronger than the markets believe. If anything, we expect rates to rise in the US this year.

So, in the longer term, we do think the pound will fall against the dollar.

The US economy is structurally too weak for the dollar to strengthen massively, but over the next year, we expect an exchange rate of about $1.97.

But we still think the pound should stay at $2 for the next three months or so.

Bad for British firms, but great news for tourists heading for summer holidays in the States.

Andrew Miller is regional centre head of Gerrard Investment Management, a part of Barclays Wealth.