Posts tagged ‘dollar’

Sterling Stuff

The British Isles have been living through some historically significant weeks. The Scottish referendum resulted in the continued existence of Great Britain as a nation, but only by a narrow margin. To say therefore that politics has been interesting here lately would be an understatement. But market behaviour, on the other hand, has not been terribly volatile. The stock market has remained completely range-bound. Gilt yields did reach new lows for the year to date in August, but there were never any signs of panic. In both cases prices have been moving in the same direction as other major markets.

Where there was some more eye-catching behaviour was in the currency.

Given the focus on the pound throughout much of the political campaign this is satisfyingly appropriate (and of course its international trading symbol clearly reads: “GBP”). The sharpest move against sterling came after a weekend poll published by the Sunday Times on 7 September showed a narrow lead for the Yes campaign. Monday saw the pound fall by 0.9% on a trade-weighted basis, its biggest one-day tumble for well over a year.

We should not get too carried away here: the euro has fallen further against the dollar since mid-year and shown almost equally great volatility this month, in no small measure due to the operations of the ECB. Still, the pound has experienced a material shift over the past twelve months and this begs the question: what is its fair value?

Trading ranges are one obvious place to look for guidance. Against the dollar, sterling almost fell to parity in 1985, and peaked at over $2 in 2007. The average cable rate for the past thirty years is parked in the middle of this range at $1.64. For almost exactly one half of that three-decade period, the pound has traded within ten cents either side of the average rate, which is remarkable. At its current price of $1.63, therefore, it looks fairly valued.

The euro rate is harder to pin down on this basis. From the launch of the single currency in 1999 to mid-2007 the pound held a range of €1.40-€1.70, broadly speaking; then it weakened dramatically towards parity in 2008 and has occupied a range of between about €1.05 and €1.30 ever since. At €1.28 currently sterling therefore looks a bit toppy on a purely post-crisis view, but a bargain relative to its pre-2008 levels. (The latter also applies if one charts the pound against the old European benchmark of the Deutschmark. If the DEM still existed a pound would buy 2.5 of them, below its averages over both the past twenty and thirty years.)

Fixating on ranges, however, is the proper preserve of traders, technical analysts and all those trying to make short term sense of the foreign exchange market (there but for the grace of God … ) The long run – and textbook – point of reference is the currency’s purchasing power parity. The theory behind PPP is that the same goods and services should cost similar amounts in different countries, assuming perfect freedom of trade between them. In practice, PPP valuations are therefore calculated by reference to the relative costs of similar items of consumption and to inflation rate differentials over time. OECD PPP estimates for the equilibrium sterling exchange rates against the dollar and the euro are $1.38 and €1.11, so the pound is actually looking expensive on this measure at the moment.

More interestingly, perhaps, are the implications of PPP for long term trading ranges. Using the OECD estimates, sterling is about 13% overvalued against the dollar. When it hit the same kind of levels about nine years ago the actual exchange rate was nudging $1.80. In other words, the somewhat higher rate of inflation in the UK relative to the US over that period has shifted the PPP valuation of the pound by about fifteen cents. Another way of looking at this is that the high reached recently of $1.72 is equivalent to $1.87 a few years ago.

Over the last three decades the UK and US economies have exhibited identical average rates of CPI inflation (2.8%), which is consistent with the stability of the cable rate’s trading range over the period. Turn to Europe, however, and the picture is rather different: over the last ten years, the annual rate of CPI inflation in the UK has on average been higher than that in the eurozone by 0.8% (2.7% as against 1.9%). Going back much further is problematic as zone-wide data is not available prior to 1997 and back in the 1980s there was the matter of the separation between East and West Germany. But the twenty year average rates of CPI inflation in France and Germany are 1.5%, compared with 2.2% here in Britain.

This means that the 14.5% undervaluation of the euro against sterling on the OECD measure pits the current rate of €1.28 against a rate of almost €1.60 when the same level of undervaluation could be observed in the autumn of 2002. So while the trading range of the currency alone might suggest that the pound is priced at a rather weak level against the euro, PPP tells us that we need to shift our assumptions to take account of the material inflation differential between the UK and Europe over the last ten to twenty years and perhaps adjust ourselves to something along the lines of the post-2008 range as the new normal.

Between the long-run PPP and the short term trading view of the world are a handful of other significant forces on the exchange rate. The desirability of UK assets, the attractiveness of the country as a place to do business, the development of views on the likely future path of interest rates and (joining all these dots together) the outlook for economic growth are hugely important considerations. But the impact of PPP, and inflation, is observably apparent.

On that basis it is not quite reasonable to interpret the recent fall in the value of the pound as a conspicuous buying opportunity. And when looking at the currency diversification of a portfolio on a medium to long term investment horizon, it is worth bearing in mind the stubborn tendency of the UK economy to inflate more quickly than its major market peers over the last decade or so, especially in the case of Europe, and to consider the possibility that this might persist.

26/09/2014 at 4:04 pm

The Year In View

As this will be the last comment to be posted for 2010, it seems the appropriate place for some reflections on the year (almost) gone by.

Since this blog began in July, one consistent view has been that while the world economy would continue to recover, it would do so patchily. Equity markets agreed. At present, the S&P 500 has risen by 11.5% year to date; the Nikkei 225 is down 3.1%. In Europe, the stronger countries turned in some of the best equity market performance in the world, with Germany’s DAX up 18.4% and Sweden’s OMX higher by 21.6%. At the other end of the spectrum, Ireland’s ISEQ fell by 4% and the Athens Stock Exchange General Index stands a staggering 33.7% below where it started the year. Our own FTSE 100 index is in the middle, having risen 9.1%.

Despite the recent sell-off, bond markets – which reached crazy levels earlier in the year – have generally turned in a strong performance over 2010 as a whole. Ten year US, German and UK yields have fallen by 40-50 basis points (0.4-0.5%) year to date, implying price gains of around 3-4%. Unsurprisingly, the exceptions were the more distressed European government bond markets, with ten year Irish bond yields 350bp higher and the yield on ten year Greek paper up by almost 600bp.

Commodities have enjoyed a strong year overall, with the S&P GSCI total return index up some 6%. Behind the headline number, the near Brent Crude future has risen 18% year to date, a figure matched by the Bloomberg Base Metal index. Precious metals continued their staggering run into precarious territory, with gold 26% higher and silver up an astonishing 73%. One of the few fallers was a significant one for the index, however: the NYMEX natural gas future is down 26% on the year.

Finally, in the world of currencies, the big loser was the euro, down over 9% on a trade weighted basis year to date. The major gainers were the safe havens of the yen (up 13.4%) and the Swiss franc (up 12.8%), and the Australian dollar got an 8% boost from the commodity boom. Both sterling and the US dollar are broadly flat.

There are a number of observations that could be made on all of this, and even some hints to be drawn about the future. For now, however, we will limit ourselves to noting the disparity of returns between and within asset classes, underlining the portfolio contribution to be made from decision making at this level. And as to the future, may we wish you a merry Christmas, and a happy and prosperous new year.

20/12/2010 at 2:52 pm

Mixed Picture

It’s been another interesting week in these most interesting of times. The Fed’s decision to purchase another $600bn worth of US bonds did not come as a surprise, but it moved markets nonetheless. Equities did best, though bonds also performed well: after all, it is the bond market that is directly affected by the QE fairy dust. The big loser was the dollar, though as its weakness has been underpinning US export growth of 15-20% p.a. of late against a backdrop of near-zero inflation it seems unlikely that this will trouble American policymakers overmuch.

Perhaps a little less high profile were Angela Merkel’s renewed efforts to secure a debt restructuring for the peripheral eurozone countries and so reduce the burden of bailing them out that has fallen on German taxpayers. But her concern should remind us that the developed world continues to enjoy decidedly mixed fortunes at present.

For there are bonds and bonds, and while US Treasuries and German Bunds have risen over the last couple of weeks on the QE story, not every country’s debt has followed suit.

The yield of 10 year US and German bonds has fallen by 0.08% since two weeks ago. 10 year Greek bonds, however, yield almost 2% more, and 10 year Irish bonds about 1.1% more, which has pushed their spread over German paper to a new record (5.3%). Similarly, 10 year Spanish government bonds have risen 0.4% to a spread of more than 2% over Germany, and Portuguese bonds about 1% to a spread of 4.2%.

This compares to unchanged yields both for the safe eurozone countries such as France and the eurozone’s seemingly safe (but lower rated) eastern neighbours, such as Russia and Poland.

Nobody serious believes that financial markets are perfectly efficient any more. But investors ignore messages like these price movements at their peril. It was only at the end of June – a mere four months ago – that equity markets found themselves nursing significant quarterly losses, in large part due to the threatened sovereign debt collapse in Greece. Despite the fact that the credit ratings of countries such as Ireland and Spain remain relatively high, the bond market is telling us on its fringes that the PIGS could well have another sting in their tail.

05/11/2010 at 10:46 am 2 comments

Gold Rush

On Tuesday afternoon, the Fed gave a statement which left the door open to further quantitative easing in the US. The dollar sold off in response and so the price of gold in dollars rose to another new record high.

So far, so reasonable sounding. The dollar has weakened by about 3% on a trade weighted basis over the last month, and gold has risen by about 4%.

There is only one problem. Over the first half of this year, the trade weighted dollar strengthened by about 5%. And gold? It went up by 10%.

It seems that in the current bull market for the metal, it’s heads you win, tails you don’t lose. Attempts to explain the behaviour of the gold price by reference to the strength of the dollar fail in the face of the facts. Likewise any effort to attribute gold’s strength to inflation, which in the US is hovering at around 1% p.a. – and whose low level is responsible for worrying the Fed in the first place. And if there’s no inflationary or devaluationary rationale for buying gold, then what’s the point? Like any commodity it yields nothing and will actually cost you money if you physically want to own it.

Gold has to be one of the biggest market bubbles around, being driven ever higher on speculative froth and spurious explanations. Admittedly this seems to be a minority view – “gold bubble” gets a mere 6 million hits on Google as opposed to 38 million for “gold fund“. Either way: how much further can the price go?

In today’s money, gold was worth more in US$ back in the early 1980s than it is now – but not for long. The inflation-adjusted price peaked at over $1,800 in early 1980, having tripled over the previous two years, before losing two thirds of its value again over the next five. The price today is touching $1,300 – almost exactly quadruple the $326 reached at the bottom nine years ago.

When you consider that during the 80s gold spike inflation in the US was running in double digits, peaking at an eye-watering 14.8%, and that today the metal is well on the way to equalling its performance back then while some commentators are still worring about deflation .. In the words of Lord Byron, a “thirst for gold” right now may well turn out to be a “beggar’s vice”.

24/09/2010 at 11:25 am 1 comment


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