Over the past quarter of a century the price of sterling against the dollar has been constrained by two simple numbers: $1 (the price sterling almost reached in the dark days of early 1985) and $2 (the price sterling has failed to crack on three occasions prior to now). With the pound once again hovering just a couple of percent below $2, it is worth considering whether it has what it takes to finally breach this elusive barrier.
The relationship between yield and currency performance is a notoriously fickle one, as any European central banker that attempted to defend a local unit at the time of the Exchange Rate Mechanism (ERM) crises of the early-1990s would attest. However, sterling has always proved particularly interest rate sensitive. It therefore makes sense when considering the likelihood of a fresh rally from current levels to consider both what the rate environment actually looked like during previous highs as well as what has been the norm throughout this period.
As of late February, sterling has managed to close above $1.90 a little over 60 times over the past 25 years. During those weeks, sterling normally enjoyed a substantial interest rate advantage over the US unit, with a one-year sterling deposit typically yielding 3.35 percentage points more than its dollar denominated equivalent. By way of comparison sterling’s current yield advantage comes in at around half a percentage point.
The current level of the pound seems even more surprising when looked at in terms of the overall averages since 1982. Although the average price of sterling against the dollar comes in just below $1.62 over the 25-year period, its average one-year yield pick up has been in excess of 1.8 percentage points. In other words, an interest rate gap in sterling’s favour of over three times that currently prevailing in the markets has normally only served to keep the pound at prices around 17 per cent below where they currently stand. In short, sterling seems surprisingly high against the dollar given the modest yield advantage it currently enjoys and sterling’s historic sensitivity to interest rate issues.
It is not just against the dollar that the pound looks overstretched. It is arguable that even against the low yielding Japanese yen the current valuations look out of line. As of the start of March sterling was trading around 20 per cent above its average price for the past decade. This came despite the fact that the pound’s one-year yield advantage over the Japanese unit was marginally less than the typical spread seen over the past ten years. This misalignment becomes even more notable when it is remembered that the last two times that sterling reached similar prices against the yen (the late summers of 1992 and 1998) the prevailing levels of yield support were substantially higher than they are today (by around 200 basis points).
What is also worrying about sterling’s current elevated levels is that it has had a history of violent retreats from similar levels against the dollar and the yen in the past. In February 1991, having briefly looked above $2, sterling managed to lose 14 per cent of its value against the dollar over the space of six weeks. Eighteen months later, with sterling back at the $2 level, the ERM crisis sent the pound skidding lower against a wide range of currencies (including both the dollar and the yen). In October 1998 (the last time that the pound was trading up at these levels against the yen) sterling managed to lose an impressive 14 per cent in one week as yen funded carry trades were unwound.
If history is any guide then investors should remain cautious about sterling’s current elevated levels.
Neil Mellor is a currency strategist at the Bank of New York.
Researched and published in association with the Bank of New York.
