Pound’s rally against euro unsustainable

THE British pound reached a 12-year high against the dollar last week. Sterling traded at 1.9438 against the greenback, and at this rate it can’t be long before one pound buys two dollars.

Sterling hasn't tested these heights in more than 12 years, not since Black Wednesday, and the exchange rate mechanism crisis of 1992.

Thankfully, the circumstances behind the pound's current rally are totally different to those which tipped Britain into recession following Black Wednesday, but the fact that it's 12 years since the pound traded at these levels shows just how exceptional the current exchange rate is.

Of course, the pound hasn't just gained against the dollar; sterling has also risen to a multi-month high against the euro. Last Thursday, the euro fell to 0.6890 against sterling, the single currency's lowest level since early October.

The euro's fall against the pound will give some respite to Irish exporters struggling with the weak dollar, but the strength of sterling is the exception, rather than the rule.

That's why we think businesses with sterling receivables should look to take advantage of the pound's current strength, before this rally ends. And we think sterling's rally against the euro will end because the pound's gains have been driven by renewed interest rate uncertainty.

Sterling last tested 0.69p against the euro in October, and at that stage the market expected that Britain's base interest rate would rise by a further 0.75% before year-end.

For currency speculators, interest rate expectations are vital, since the higher the interest rate, the higher the yield available on currency deposits. That's why expectations of higher British yields saw demand for the pound soar earlier this year, pushing the euro/sterling exchange rate down to 0.65p.

But that interest rate outlook changed sharply in November, following weaker than expected property price surveys and disappointing British economic indicators.

By mid-November, the market had revised its view on British interest rates to expect no further hikes this year. That's why the pound fell to 0.70p against the euro until last week.

Following an unexpectedly strong British purchasing manager's index for November, and hawkish comments from the Bank of England, the market has again started to look for a British rate hike possibly before Christmas.

But sterling may have over-reacted to the Bank of England's comments. Charlie Bean, the Bank's chief economist, last week warned of significant inflationary pressures in the pipeline, hinting that UK rates may have to rise again.

But with intense competition on the British high street, it's unlikely that these inflationary pressures will ever make it through to consumer prices.

Therefore, these pressures are unlikely to force rates much higher.

That's why we think the pound's current rally against the euro is unsustainable. The Bank of England announces its monthly rate decision next Thursday, and if rates stay on hold, then a disappointed market could soon push euro/sterling back toward 0.70p.

The views and opinions expressed in this article are those of the author and do not necessarily correspond with those of Ulster Bank or any other member of the RBS Group.