The new bull market in sterling is just beginning

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Just after midnight on 7 October, 2016, sterling slipped to $1.14 in the so-called “flash crash”.

The pound is the oldest currency in the world. Bar a few days in early 1985, this was the lowest level it had ever sunk to.

The political uncertainty which followed the Brexit vote had spooked the currency markets.

Things are looking rather different now.

The dollar is weak – but the pound is also strong

Today the pound is at $1.40. From low to high that would make this a 20% rally in the pound since October 2016 – for a currency, that is no small beer.

In 2018 so far, the pound has even outperformed bitcoin! (Mind you bitcoin is currently in a bear market, so the comparison is not fair.)

Much of these gains have been, quite simply, because the US dollar has been so weak.

One of President Trump’s stated aims was a weak dollar. In that, he has been successful. Tuesday 3 January, 2017, marked the high in the US dollar index (that’s the US dollar versus a basket of the currencies of its major trading partners). It was the strongest the dollar had been in the 15 years since 2002.

The dollar has been falling ever since, which is one of the reasons asset prices – particularly stocks – in the US have been doing so well. Quality assets and a cheap currency attract capital, and so international capital has flowed to the US.

But the pound’s strength has not just been a function of US dollar weakness. Since Theresa May’s election “mix-up” (which brought uncertainty and pound weakness) of last summer, the pound has been rallying against the Aussie dollar, the Canadian dollar, the New Zealand dollar, and the Singapore dollar.

It’s also been strong against the Japanese yen, against the euro and against both the Swedish krona and Norwegian krone. It’s been strong against just about everything – because this is a bull market.

Even Mark Carney and the Bank of England haven’t been able to talk it down – and that’s saying something.

The question we must now ask is – how much further can it go?

Sterling is still in the foothills of this bull market

On a short-term basis – and by that I mean over the next few weeks – I would not be surprised to see a small pullback and some consolidation. On a longer-term basis, I remain bullish.

Bull markets often begin from oversold levels – when an asset is too cheap. Think gold at $250 an ounce in 2001; think US stocks with the S&P 500 at 666 in 2009. First they go through a phase where nobody believes it – and so the majority stay out. Eventually, they reach fair value. And finally there’s exuberance, when everybody jumps on board for fear of missing out.

Gold reached the exuberance phase in 2011. Bitcoin reached it late last year. US stocks are somewhere in the exuberance stage now (and that doesn’t mean they can’t still go a lot higher).

Sterling reached the opposite of that stage in October 2016. It was doomed. “Buy, buy, buy” I said and, oh, how they mocked me.

Though people are slowly coming round, I’d say that now sterling is still is somewhere late in the “nobody believes it” phase – or perhaps “few believe it” is a better way of putting it. Though there are many who believe and have always said that Brexit will be good for the economy, many others – and particularly the media – still seem to think it is a disaster.

Every time there is good economic news, the phrase “despite Brexit” still appears. That unemployment is low, growth is good, stocks are strong, investment is running high – and sterling is rising – doesn’t seem to matter.

It’s not even fair value yet. On a purchasing power parity (PPP) basis, sterling is also undervalued. Analyst Charles Ekins of Ekins Guinness calculates the relative PPP of currencies based on relative inflation, which is similar in principle but not the same as measuring the prices of a relative basket of goods.

Ekins calculates that fair value for sterling against the dollar is $1.60 (versus the current price of $1.40). Against the euro it is €1.20 (compared to the current price of €1.13). Thus sterling, even after its run, remains undervalued against both, albeit not by as much as it was.

What few seem to have considered is that sterling could not only reach fair value, but exceed it. That is what happens in bull markets.

Here’s what could drive sterling a lot higher – maybe even to $2

We are still many years from this, of course. But there are all sorts of things, which could continue to move sterling higher.

First, of course, there’s the economy. The general mood is that the economy is doing well at the moment. It could continue to do well. It may even be that leaving the EU leads to an economic boom. We continue to stumble our way through the divorce without too much harm done. We secure all the trade deals we want outside the EU, and they’re good deals. Trade and exchange increase. Overseas investment piles in. Britain thrives. Unhampered by EU regulation, Britain outperforms its neighbours. The economy expands. It’s all possible.

Second, we get a good prime minister. If there’s one thing that characterises Theresa May, it’s that, like the hardiest of cockroaches, she is a survivor. She’s not popular; she lacks the common touch; she seems unable to offer any opinion about anything. This lack of apparent clarity means that every time she has to do anything – an election, a cabinet reshuffle – there’s no guiding philosophy and thus incompetence always raises its head. But she’s still there.

But the word is she does not particularly want to be there. It is only the lack of clear alternatives that is keeping her there. I doubt she’ll be allowed to run another election and it’s not beyond the realms of possibility that she stands down before and a new leader of the Tory party is elected.

Say Corbyn-mania also proves to be a passing fad. The new leader wins the next election with a strong majority and we actually do get a “strong and stable” government. We don’t have one at the moment. If we did, that too would be extremely sterling bullish.

Finally, there are rising rates. The Bank of England base rate is still 0.5% – an extraordinarily low number when looked at in a historical context. It is possible that the interest rate cycle has bottomed, and that rates creep up from here. (In the US, ten-year yields just hit three-and-a-half-year highs).

Heck, even Carney might put them up. But he is set to leave in June 2019. What if the next governor wants to return us to monetary normality?

Higher rates – assuming they are not driven up by some financial panic – would also be good for the pound.

But these triggers are all long-term boosters that are some years off. For now we remain in the “few believe it” phase.

Regular readers will know I’ve been calling a bull market in sterling for some time now. Based on Frisby’s Flux (the eight-year cycle in the pound), I’m looking for a high somewhere around 2022-23.

By then, who knows where the pound will be. It may sound ridiculous, but I would not rule out $2. We’ve been there before. If this bull market properly takes off, we could eventually get there again.