Following an extended period of low volatility in global currency markets, the dollar has fallen sharply against sterling since mid-November. With the pound rising to above $1.96 against the dollar on November 30 – an increase of 4% since November 18 and 14% since the beginning of the year – sterling is at its strongest level since September 1992, when Britain left the Exchange Rate Mechanism. The dollar has also lost ground against the euro, having fallen by 12% so far this year.
While the dollar’s devaluation has been fairly steady against both sterling and the euro in recent years, the most recent adjustment has led to concerns that export-reliant British and European companies will suffer significantly if the dollar continues to tumble.
Several factors point to the recent acceleration in the dollar’s decline. It is accepted that the American economy is slowing, but uncertainty surrounds the rate at which this will happen. Markets may have become more concerned about the prospects of a hard landing in America, and hence the need for intervention from the Federal Reserve in the form of earlier-than-anticipated rate cuts.
In contrast, the European Central Bank continues its tightening monetary policy, with most major European economies appearing healthier than America’s. There is also the possibility of further interest rate rises from the Bank of England. With tightening interest rate differentials between America (currently 5.25%) and Britain (5%) and the eurozone (3.25%), investors may look to non-dollar currencies for the potential of higher yields, thus reducing dollar demand.
Keith Wade, chief economist at Schroders, says: “Based on forward interest rates, the market expects US rates to be about 4.5% by the end of 2007, with a rate cut by the middle of next year. This is maybe quicker than had previously been expected.”
Interest rate expectations in Britain are relatively flat, with a possible increase in the short term, while recent comments from the European Central Bank hint to further rate hikes next year, he says. “With a slowdown in the US and the eurozone looking strong there is the potential for a decoupling in the economic cycle,” Wade adds.
America’s current account deficit, which stands at about 7% of its GDP, is also putting downward pressure on the dollar. To fund domestic consumption, America has relied on Asian central banks accumulating dollar reserves, but whether this is sustainable in the long term is the subject of much debate.
Wade says: “Questions are being asked about the sustainability of China buying US dollars, and whether it is the best use of their resources to accumulate such high levels of reserves. The People’s Bank of China has indicated it is looking to diversify reserves, which does not help sentiment for the dollar.”
While the Japanese yen has appreciated against the dollar in recent weeks, it has not gained as much as sterling and the euro. Indeed, the dollar-yen exchange rate is largely unchanged from the beginning of the year, with the yen depreciating strongly against European currencies.
One important feature of global currency markets is the carry trade. By borrowing currency in a country with low interest rates – most notably Japan – and channelling assets into currencies with higher interest rates, investors can profit from the yield differential. The risk, of course, is if the currency of the country with the higher interest rate depreciates more than the additional yield gained. Conversely, if a carry trade gains momentum, demand for the higher-yielding currency can push its value up and hence further increase profits.
Thanos Papasavvas, head of currency management at Investec Asset Management, says: “From January to mid-May 2006, it was an environment in favour of value currencies. The Japanese yen, Swiss franc and euro all performed well, while the US dollar and New Zealand dollar lost ground. But following stockmarket volatility in May, the carry currencies started to perform and the yen depreciated. There is no reason to suggest that the yen will appreciate and we continue to use it as a lending currency. The yen carry trade will continue, but to a lesser extent.”
While Papasavvas is unsure how economic dynamics will pan out, he sees the euro and sterling appreciating against the dollar in the short term. “We are overweight European currencies, underweight the US dollar and marginally underweight the yen,” he says.
Colin Harte, manager of the £103m Baring Directional Global Bond trust, says: “We have been negative on the dollar for some time and, with the return of volatility in markets, we expect a significantly weaker dollar over the next few months.”
Unlike Papasavvas, Harte is bullish on prospects for the yen and his fund has an anti-carry trade bias. “We expect the Bank of Japan to be more hawkish, with the pace of monetary tightening increasing more than the consensus,” he says.
“We also think US rates could be cut more aggressively than expected, with investors demanding a higher risk premium for holding dollars. Investors could move back to their base currency and the yen carry trade could take quite a squeeze.”
For British investors with sterling liabilities, the depreciation of the dollar and the yen has not helped the performance of investments in the American and Japanese stockmarkets. Jeremy Tigue, head of global equities at F&C Asset Management and manager of the £2.4bn Foreign & Colonial investment trust, says: “Currency movements have hampered performance of some underlying overseas markets for sterling investors. The US market is up this year but the fall in the dollar has taken returns away. Japan is even worse because the underlying stockmarket is down too.
“However, some sectors have benefited from exchange rate movements, including export-based companies in Japan and America. More and more American companies are generating profits outside of the US.”
Tigue adds: “There have been concerns that currency volatility could feed through into stockmarkets, but despite the weakening of the dollar, we have not seen much movement in stockmarkets.”