Sterling has almost continuously been stronger against the Euro, since the start of the new currency's life. Having been fixed at about 0.6950 and rising to 0.7050 on day one, the Euro has fallen to a low of 0.6370 before a modest recovery recently. Interestingly, the Pound has also slipped recently against the Dollar, having been stable for much of 1999 to date. This latter fact is probably key for understanding Sterling's past and future performance against the Euro.
Rather like the Bank of England, we find it very hard to explain directly Sterling's supposed strength against the Euro, especially given that current UK activity is probably half the rate of that in Euroland, given that the UK external position is deteriorating badly and that UK interest rates have fallen. In our models, we cannot satisfactorily directly explain Sterling strength.
In contrast, our models can explain US Dollar strength against the Euro. Driven by stronger than expected economic activity and fears of higher US Interest rates, a widening 10 year bond yield spread versus Euroland has propelled the Dollar higher. At one stage a couple of weeks ago, the spread was as wide as 175bp over comparable Eurozone bonds. On our models, a 1% yield spread shift in real term's accounts for an 8.5% move in the Euro versus the Dollar. At its recent widest therefore, the 175bp differential would justify the Euro being 15% below its fair value against the Dollar. Give that we'd estimate fair value to be 1.24, a move to 1.08 is fully explainable.
The remaining 5% Euro weakness probably reflects some risk premia that does relate to more structural concerns, but we would suggest that cyclical factors outweigh such fears over structural issues by a ratio of 3 to 1.
As said earlier, we cannot do the same for the Pound against the Euro, especially as the interest rate differential between the UK and Euroland has been more stable. Against the Dollar, until recently the Pound had held up well, and we think that this reflects peculiarly active acquisition activities by US Corporations purchasing their 'cheaper' British counterparts. With P/E ratios very expensive in many US industries, the UK seems relatively cheap, and with the open and clear disclosure business practices, the UK has been a fertile ground for US expansion into Europe, the recently announced move by Wallmart being a good example. US corporate demand for Cable has been strong therefore, sheltering the UK from the cyclical strength of the Dollar.
As and when, Europe starts to attract more US company acquisition Dollars., this may help change the situation. We do think that this may emerge, not least as we forecast that the cyclical differences between the US and the Eurozone will reverse. In fact, we forecast that in the year 2000, real GNP growth will be about 2 1/2% in both the US and Euroland, the US slowing from above 4% this year, whilst Euroland accelerates modestly. Taken together with the ever widening US BoP current account deficit, and the relative cheapness of Euroland stocks compared to the US, a stronger Euro will emerge before 1999 is over, and accelerate in 2000. We forecast a EUR/$ appreciation to 1.16 and 1.24 in 6 and 12 months time.
If the EUR/$ does appreciate, then Sterling strength will disappear very easily, and in fact, if US acquisitions in the UK slowed, the Pound could easily be even weaker than it was at the start of 1999 at the end of this year. On top of the fact that GNP growth of about 0.7% in 1999 will be close to just 1/3 of that in the Eurozone, a significant deterioration in the UK external position will be relevant. We forecast that by next year, the UK will have a current account deficit close to 2% of GNP, which will compare with a surplus last year of around 0.2%. This will be lead by a further sharp deterioration in the trade accounts, a reflection of the continued weakness of UK manufacturing and relatedly, evidence of Sterling's misalignment against the Euro. We estimate that the equilibrium for Sterling is approximately 0.78 to 0.79 against the Euro, more than 20% weaker than today's levels.
If the UK were to ever join EMU, then a level close to our estimated equilibrium would be appropriate and likely joining level. In this regard, watching words and hints on the UK stance towards EMU participation will remain a favourite FX dealers pastime.
What is the attitude of the UK Government towards EMU? Has it been affected by the poor showing of the Labour party in June 10th Euro elections? At times, it can seem as though there is no difference between the stance of the current Government and that of the last Tory Government that led to the deep divisions and John Major's departure. The careful appearance of non-committal by PM Tony Blair, and most of his close aides has if anything been strengthened by the Euro election results, as the Government continues to try hard and reflect the interests of its voters.
However, we think that it is important to watch the specific words of Mr Blair and those close to him. Since the Euro election results, they have repeated their commitment to joining EMU "in principle", and that a decision on whether to recommend a referendum will be made early in the next Parliament. Whilst Chancellor Brown has stated that today the 5 Convergence Tests set out to determine whether UK membership is suitable would not be met, they are sufficiently flexible to easily allow a different view when and if the Government decides. As for the Government's strategy, watch for the beginning of the cross party 'Britain in Europe' group this month to see whether Mr Blair gives any further hints.
Looking at UK opinion polls, whilst there is clear opposition towards EMU, which has recently risen further, it is also interesting to see that a majority continue to anticipate that membership is likely. Given that the same polls show continued popularity of the Blair Government, it does seem as though the Government will be able to shift the electorates thinking on the Euro. We continue to anticipate a May 2001 election, followed soon after by a decision to call for a referendum in late 2001, with aggressive campaigning from the Government. Actual EMU entry is likely by 2003, with perhaps a chance of 2004 if technical matters take some time to resolve.
In the event that EMU membership does not materialise, then the Pound will be free to concentrate on purely following the fundamentals.
All in all, whilst Sterling has strengthened against the Euro in it's infant life, as the Euro matures and grows, it is highly likely that the Pound will reverse its strength, but it will require a more generalised Euro recovery against the Dollar. Given that we expect this to occur it is still possible that the Pound will end 1999 weaker against the Euro than where it started, and in 2000, a weaker Pound seems highly probable with or without UK EMU participation. |
