Take a look at any calendar of economic data, and somewhere in the world new figures will be being released on a daily basis, which in turn will affect a country’s exchange rate such as that for pounds to dollars. The UK pound is used as a reserve currency around the world, and is currently ranked third in the amount held as reserves. The percentage of reserves has increased steadily in recent years due to the stability of the UK economy and a gradual increase in value against many currencies. This has been particularly true against the US dollar which has weakened significantly in the last few years as a result. Naturally the relatively high interest rates have played a part, so let’s look at the major factors which dictate the likely movements between the currency pair.

Before we cosider some of the more important economic indicators, let me try to explain the role interest rates play in the relationship between the two currencies. The most widely watched, and easily understood indicator of the economic health of a country , and hence it’s currency, are interest rates. Since 1997, the responsibility for setting and maintaining interest rates in the UK has been that of the Bank of England, whilst in the US these are set by the Federal Reserve. The reason interest rates are watched so closely is because it is one of the few instruments that governments and central banks have available with which to offer some form of control over the economic stability of the country. In simple terms, rate changes are used to control inflation, but in reality any rate change has long term effects in a variety of ways. These include imports, exports, the balance of payments, housing markets, and general feelings of economic wellbeing, or otherwise, in the working population . Any rate decision therefore provides a view on the economy from the central bank, but more significantly will have a long term effect on a variety of economic fundamentals. Having said that, interest rates alone are a relatively blunt instrument with which to control economic events, and in general any rate change will take at least 12-18 months to feed into the system, and on into any subsequent economic data. Any reduction in interest rates makes saving less attractive and borrowing more attractive which in turn will stimulate spending. Lower rates also tend to boost financial markets such as share prices, and assets such as property.

An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign currency equivalents, tending to make sterling assets more attractive. Therefore demand for UK pounds will rise. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad. However, the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable. In general, the BOE and many other central banks use interest rates to control inflation. If inflation in the UK is lower than elsewhere, then in simple terms UK exports will become more competitive, which in turn is followed by an increase in demand for the currency. In addition, foreign goods and products will become less competitive as the the pound strengthens with the demand for the currency and the dollar weakens. Now it is important to realise that in any analysis of interest rate differentials between two currencies, one must also consider the speculators view of the market ( in this case you and I!!) If speculators believe that the pound will rise in value in the future, then they will buy the currency in order to make a profit. This increase in buying will cause the currency to rise in value, and for the dollar to weaken and fall in value.

For the last few years, both the UK and US economies have shown strong and steady growth with interest rates increasing and keeping pace with this growth. However in the last year, with the collapse of the US housing markets following the sub prime debacle, and coupled with a banking crisis in both the UK and US markets, many economists now believe that the UK pound is unlikely to stay above $2 dollars for much longer, for several reasons. Firstly, if we consider the likely interest rate moves in the next twelve months, then it seems almost certain that the US rates will be cut significantly in order to stimulate the economy, and to support the housing and financial markets, which has indeed happened in the last few months. In addition to the economic effects outlined above, this will also encourage speculators back into the ever popular carry trade, which has been largely ignored in the last few years whilst rates between pounds to dollars have been very close.

In the UK, the interest rate decision is less clear cut. Whilst the overall economy is undoubtedly entering a recession, as is the US, the UK problem is compounded by the spectre of inflation. Terrified that reducing rates will add to inflationary pressures, the BOE are currently trapped on the horns of a dilemma, where reducing rates will prevent a crash, but increase the likelihood of inflation – a term often referred to as stagflation. Prior to the 1970s, the prevailing Keynesian school of macroeconomics assumed that inflation and stagnation were unlikely to occur together. In other words it was considered impossible that an economy could stagnate, whilst inflation increase simultaneously. Interestingly the problem in the 1970’s was also as a result of a dramatic increase in oil prices worldwide. With oil now having fallen from the highs of $150 a barrel, and coupled with substantial commodity price rises in basics such as wheat and cotton, then the decision for the BOE is far from straightforward. In my view I would expect the BOE to cut in the next 12 months by at least 100 to basis points and possibly as low as 0.25%. The similiarities to the Japanese banking crisis of the 1990’s is stark and alarming, and without wishing to sound like a doommonger, this situation could take years to resolve, with the country left virtually bankrupt.