Monday, March 4, 2013

Sterling update: still somewhat expensive

Last Friday I suggested that the dollar was still very weak against a large basket of currencies. This post focuses on the dollar's value vis a vis the British Pound.


The green line in the above chart is my calculation of the Purchasing Power Parity of the dollar/sterling exchange rate. This is the rate that in theory would make prices equal between the two countries. At this rate U.S. tourists to the U.K. would find that on average goods and services cost about the same there as in the states. The rate is calculated by using a base year for the exchange rate (i.e., a period during which prices where roughly equivalent between the two countries) and adjusting that rate by the difference in inflation over time between the U.S. and the U.K. The PPP of the pound has been falling over the entire period of the chart, which means that inflation in the U.K. has been higher than inflation in the U.S. So the PPP value of the pound must fall in order for prices to remain equal (i.e., the weaker PPP value of the pound offsets the higher nominal prices in the U.K.).

As a rule of thumb, significant deviations between the value of a currency relative to its PPP value reflect stronger/weaker demand for the currency, which in turn is related to confidence in a country's fiscal and monetary policies, and/or the outlook for the economy.

Currently, I estimate that the pound is about 10-15% overvalued relative to the dollar. If I'm right, that means that goods and services cost about 10-15% more in the U.K. than they do in the U.S. This is down significantly from the 40% overvaluation of the pound in late 2007. The dollar was weak against almost all currencies back then, and it had been falling for the previous 5 years. The Euro was also quite strong at the time, and Eurozone equities had outperformed U.S. equities for 5 years running. As I see it, the world was much more optimistic about the future of Europe at the time than about the future of the U.S. Today the world is losing its enthusiasm for Europe as the list of things to worry about (relatively high public debt/GDP ratios, relatively high tax rates, large unfunded pension liabilities, sovereign debt defaults, a potential breakup of the ECU, the inability of most states to cut back on excessive public sector spending) lengthens. Meanwhile, things haven't been as bad in the U.S. as had been expected.

If the U.K.'s troubles prove to be deep-seated, intractable, and worse than the troubles still plaguing the U.S., then the pound is likely to fall further against the dollar. In a worst-case scenario, there is little reason why the pound couldn't again approach parity with the dollar, as it almost did in 1985. For the time being, I'd be reluctant to be long the pound vis a vis the dollar. U.S. investors would be wise to ensure that any investments they have in Europe or the U.K. are not exposed to currency risk. U.K. investors might want to leave the currency exposure of any U.S. investments unhedged.

18 comments:

Rob said...

Thanks Scott, very helpful. Do you have any view on the UK Government's just announced subsidizing of UK mortgages by up to 20%, with basically free money (no interest for five years) ? In parts of the country like the South-East and London, this unexpected incentive comes on top of already very expensive housing, indeed many say london is already a bubble. Is this latest move (from a right-wing government) a redux of the US sub-prime problem ??

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Rob said...

Scott, after his first big "show and tell" today, new Governor of the Bank of England Mark Carney seems to have reassured the markets and Sterling is having another good day. Do you think Sterling will now be able to defy gravity for sometime longer ? Thanks !

Scott Grannis said...

One problem with Sterling is the UK's relatively high rate of inflation (3+%). Carney wants to put more emphasis on goosing the economy than bringing inflation down to US levels. That suggests that Sterling will continue to remain under pressure to depreciate against the dollar.

The one saving grace is that the UK economy does appear to be picking up.

I would want to see some better growth-oriented fiscal and monetary policies before getting excited about Sterling's long-term prospects.

Rob said...

Thanks very much Scott.

Rob said...

PS. Scott, if you ever did "become excited" about Sterling's long term prospects,what would you consider to be fair value ?

I'm asking because you equated currency premiums with higher share PE ratios - ie expectations that the currency economies will grow faster than the US economy.

Right now Sterling seems maybe 20% above PPP, at 1:1.56. I just find it quite mysterious how the forex markets decide what sort of "PE ratio" premium to assign to currencies - and how dramatically this can change !

Many thanks again if you are able to shed any more light on this subject.

Rob said...

Scott, is the sterling-dollar PPP still at 1.33 ? Thanks. Sterling has continued its strong run, buoyed by new Governor of Bank of England, Vodafone sale to Verizon and other positive data for UK economy, eg today on falling unemployment claims.

Scott Grannis said...

According to my calculations, it's still 1.33.

Rob said...

Great, many thanks Scott !

Rob said...

Scott, more than 6 months after you wrote this post, Sterling has strengthened by about 8% ... and not for the first time I'm now on the wrong side of a trade ! Any advice ?!! Thanks!

Rob said...

"That suggests that Sterling will continue to remain under pressure to depreciate against the dollar."

... or not ! In the long we are all dead .. but in the short and medium term there are opportunities aplenty to win or lose money ... once again Scott you called this one very, very wrong.

Rob said...

Can't you just say "I was wrong" ? Is that too much to ask ?

Scott Grannis said...

Being wrong with currencies is easy. I would expect to eventually be right with sterling/dollar, but for now I'm wrong. It's very risky to speculate with currencies.

Rob said...

Thank you.

Rob said...

You expect to be eventually right ... In the long run we all dead ... That is a classic economist cop out. Pound now heading to 1.70 dollars. Oh boy, were u seriously wrong on that call. Keep dollar investments unhedged, u said, at 1.51 !!

Rob said...
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Rob said...
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Rob said...

If it was "still somewhat expensive at 1.51, what is it now at 1.71, Scott ? Good call btw.

Chart says it could well go to 1.80 from here.