Are we seeing a top for the pound?

The value of a nation’s currency is influenced by many things, but the outlook for interest rates and economic growth play a big part.

Last week, the sterling index (which measures the value of the pound against the currencies of our major trading partners) hit its highest level since the end of 2008 (see chart). The pound also was at its highest against the US dollar in four and a half years.

The reasons for this strength are fairly straightforward. The economy is growing strongly. The unemployment rate has fallen below the 7% threshold once put forward by Bank of England governor Mark Carney as a cue to consider raising rates.

Wages are (finally) growing faster than inflation – if you use the headline Consumer Prices Index (CPI) measure at any rate. And house prices are rising at their fastest rate for years, albeit skewed towards a bubbly London market.

As a result of all this, some analysts believe the Bank will finally have to raise interest rates to cool the economy down. Economists at Nomura and Santander, for example, think the Bank base rate will hit 1.75% by the end of 2015, compared to just 0.25% now.

Just as savings accounts with higher interest rates are more popular, currencies with higher interest rates (assuming the economy is also doing reasonably well) also tend to attract investors, which explains why the pound has been rising.

Trade-weighted pound sterling chartBut will they really rise by that much? While inflation may take off in the future, the Bank is hardly under pressure right now.

CPI rose at an annual rate of just 1.6% in March, below the Bank’s central target of 2%. The Bank is also keenly aware that many households still have very high levels of debt and could not cope with rates much higher than they are now.

Then there’s the issue of the value of the pound itself. Several companies – most recently, fashion brand Burberry – are complaining that its strength is making their products more expensive on world markets, and hitting their profits.

Minutes from the Bank’s latest rate-setting meeting (in April) also highlighted the lack of inflationary pressure, while the vote to keep rates on hold was unanimous.

All in all, says Capital Economics, “it still seems unlikely that the Monetary Policy Committee will raise interest rates within the next year or so”. A further rise in the pound is by no means certain.

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