The days of the $2 pound now a fond memory

Aug 27 2008 by Andrew Miller, The Journal

FOR most of the past year, America effectively put itself on half-price sale. With sterling at around $2 for much of 2007 and 2008, US holidays and consumer goods felt like a bargain.

But that tide is now turning. The dollar has rallied strongly over the past couple of weeks, while the pound and the euro have weakened. Sterling fell sharply last week after the UK economy posted its weakest performance since the recession of the early 1990s. On Friday, the pound slid 1.4% to around $1.85, close to a two-year low.

Meanwhile, the previously rampant euro has fallen to a six-month low against the dollar, trading below $1.46 per euro on Tuesday. Even Warren Buffett has backed the dollar – he stated last week that he had ‘no bets against’ the currency, helping to boost it further.

The dollar has been supported by the fall in the price of oil, from a high of $147 a barrel to around $115 a barrel. For a country as energy-dependent as the US, this makes a big difference.

Another factor helping the greenback is a reduction in the difference between US and European interest rates. Over the last year, US interest rates have been slashed aggressively relative to the UK and Europe in reaction to the US housing market slowdown, making sterling and the euro a more attractive place to put cash.

But Bank of England’s latest inflation report hinted that Mervyn King and his colleagues have chosen to focus on slowing growth in the UK economy, rather than rising inflation. As a consequence, markets decided that rates are likely to fall from the current level of 5% – which makes the pound look less appealing.

Meanwhile, the European picture is also bleak, with some analysts believing the euro economy could already be in technical recession. Although the European Central Bank has made hawkish noises about inflation in the past, markets now think it is less likely to raise rates.

So can the US dollar continue to strengthen? Probably not. The economy has just had a temporary boost from George Bush’s tax rebates, and growth will continue to slow towards the end of the year.

My colleagues at Barclays Capital predict that the euro will rebound against the dollar over the next three months – though the outlook is less positive for sterling.

In the longer term, the dollar is unlikely to strengthen in a lasting way until it is clear that the US economy is out of danger. Meanwhile, the euro should remain relatively strong until interest rates fall significantly, which is more likely to be a story for 2009 than 2008.

Finally, the outlook is pretty bleak for sterling. Interest rates are likely to fall, and the UK’s persistent trade imbalance will unwind over the coming months. The memory of the $2 pound is likely to stay just that – a fond memory.

The European picture is also bleak, with some analysts believing the euro economy could already be in technical recession