Sterling spent the last month moving ahead against the US dollar and falling back against the euro. Against the Japanese yen it is all but unchanged. Investors seem to prefer the pound to the dollar and would rather have the euro than either of them. In essence this is true but the reasons are not so obvious as at first sight.
Every three years the Bank for International Settlements (BIS) carries out a survey of the wholesale foreign exchange market, the business that goes on between banks and their corporate customers and between one bank and another. This year’s survey confirms the findings of the last dozen years: sterling is the fourth most heavily-traded currency, taking a part in 13% of all FX business. Its nearest competitor is the Australian dollar with less than 8% of turnover. That is not enough to put it in the premiership. The Japanese yen accounts for 19% and even that is a distance off the top two. The euro accounts for 39% of all turnover -$1.56 trillion a day – three times as much as the pound, and the US dollar is king of the hill, taking a part in fully 85% of global FX transactions (by volume). This concentration of turnover, and therefore of liquidity, has been relevant to the pound’s underperformance against the euro in September.
Investors have taken against the US dollar. At the beginning of the year it was the US economy delivering the good performance. It looked at the time as though the States was hauling the rest of the world out of recession and investors took a shine to the dollar. Since then the picture has changed. The US economy grew by just 0.4% in the second quarter of the year. Over the same three months the euro zone expanded by 1.0%, Britain achieved 1.2% growth and Germany left the Old World countries eating its dust with 2.2% growth. US re-employment has stalled; the last few months have seen job losses, not new ones. Investors have been reducing their holdings of dollars.
Back to the BIS survey. Investors wanting to unload dollars must buy another currency instead (unless they want to buy gold or some other non-currency investment, and there has been plenty of that). What is the easiest currency to buy as a replacement for the dollar? Look at the numbers. The euro/dollar market is three times as liquid as the sterling/dollar market. For dollar-sellers it is almost a no-brainer to flip into euros. Of course, thoughtful traders could decide to diversify into Australian dollars, Brazilian reais (very popular these days) or Russian roubles but on the spur of the moment, when something hits the fan and they want to offload dollars, the quick and easy decision is to buy euros instead.
In September the euro was the right currency in the right place at the right time. That is not to say there are no misgivings about the UK and the pound. House prices are slipping and mortgage approvals are few and far between, government borrowing remains high, the Bank of England is considering an extension of its “quantitative easing” bond-buying and, most of all, there are risks that the chancellor’s public spending cuts could derail the recovery.
Yet the International Monetary Fund has ridden to the rescue. It has strongly supported government policy. It sees the economic recovery “under way”, it believes the austerity budget is “appropriately ambitious” and that “fiscal tightening will dampen short-term growth but not stop it as other sectors of the economy emerge as drivers of recovery.” Bearing in mind that the IMF is the body that must step in to pick up the pieces after a government has irredeemably screwed up its budget, it is not one to big-up a policy that it thinks will make its life harder.
As long as the market is rebalancing from the dollar to the euro it is likely that sterling/euro will remain under pressure. It does not mean that sterling is disliked in isolation; it is at least partly a side effect of the way the market works. Does that mean it is due for a rebound? No, but it does mean that recovery is by no means out of the question.