The US and UK economies are both on the road to recovery. But while the Americans are roaring down the freeway, the Brits are bumping along the hard shoulder.
Although the direction of travel may be the same, the pace is very different. The US economy started its journey back to health earlier, and is now between 12 and 18 months further along the track than the UK.
Nick Colling, Senior FX Analyst, Cambridge Mercantile Group
The two countries’ fortunes are aligned, but not adjacent – and this will inevitably stretch the Sterling/Dollar relationship.
A stream of upbeat economic news from the US this year has led to a considerable strengthening of the Dollar. American banks have largely purged themselves of bad mortgage debts, the country’s housing market is recovering and the US economy is creating new jobs.
The resulting optimism has led the Dollar to rally substantially against the Pound – from 1.62 at the start of January to 1.48 in early July.
The rate of US economic growth is steady if not stellar. American GDP will rise by 1.7% this year and 2.7% in 2014, reckons the IMF.
US is Fed hot, UK is just hot
But the more immediate spur for Dollar strength is the prospect of the Federal Reserve turning off the quantitative easing (QE) tap. The Fed’s Chairman has hinted that he will reduce, or ‘taper’, its massive money-printing programme as soon as September.
By contrast, his opposite number at the Bank of England has given no timetable for when the UK’s QE programme will be scaled back, saying only that in future it will be part of a ‘mixed’ monetary policy strategy.
Governor Mark Carney has also said he is in no hurry to raise the UK base rate from its record low – all of which has hardly inspired foreign investors to start snapping up Pounds. So as the mercury rose to uncharacteristic highs across Britain in July, Sterling wilted.
Greenback and forth
While the US economy’s rebound has picked up enough momentum to feel almost irresistible, there is nothing inevitable about the Dollar’s continued rally. A steady appreciation against the other major currencies now looks more likely than the sort of bull-run the Greenback enjoyed in the late 1990s.
There are two reasons for the lingering question mark over its upward trajectory. The first is interest rates – even when the Fed starts easing down its bond-buying as predicted later this year, it is unlikely to raise its current near-zero benchmark interest rate for years.
The second is the Fed’s own reluctance to see a fast-rising Dollar. No central bank would want its currency become too strong while growth is still relatively scarce. As a result, many Dollarwatchers are predicting a sustained but shallow rally for the US currency.
Sterling’s prospects are less clear-cut, and so while the UK and US economies are moving in the same direction, there is considerable scope for volatility in the USD/GBP pair.
Hedge for heroes
The Pound’s overall fall in value this year has made British goods and services relatively cheaper for US customers, giving UK exporters a welcome boost.
But the danger of short-term volatility remains. For British firms doing business with America, sudden currency fluctuations can be disastrous. Tight margins mean a company’s profit on a deal can be wiped out if the exchange rate unexpectedly goes against them.
So the need for robust hedging strategies is as great as ever. Even though both countries’ economies have entered calmer waters, the GBP/USD exchange rate could stay choppy.
British exporters rushing to sell Royal Baby-themed souvenirs to American fans of the monarchy should consider taking out a forward contract too.