A turning point for sterling? Don’t bet on it

After sliding against the dollar in recent weeks, the pound has bounced back. But don’t think the plunge is over just yet, says John Stepek. Here, he looks at the truth behind the rally.

Sterling had a rare good day yesterday.

The pound went from around $1.49 against the US dollar to above $1.51 this morning. That's quite a big jump over such a short period of time.

What happened? Well, Bank of England boss Sir Mervyn King came out and said he thought the pound had fallen far enough. He also sounded more upbeat on the economy than he has in quite some time.

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King of course is in charge of monetary policy. So if he's feeling cheerful, you'd think that would be good news for the pound.

So is this a turning point for sterling?

I wouldn't bet on it

Sir Mervyn King talks up the chancellor

As Chris Giles puts it in the FT, Mervyn King has "sounded the alarm over sterling's vertiginous fall." Last night, King told ITV News that "we are moving to a properly valued exchange rate. I think we're probably there."

As for the Bank of England's views of the currency: "We're certainly not looking to push sterling down. We're looking to ensure recovery in the UK economy and gradually bring inflation down back to our 2% target."

He also backed George Osborne's strategy of trying to cut the budget deficit, while leaving the heavy lifting to the Bank of England.

All very reassuring. No wonder the pound has been enjoying a bounce. But I wouldn't take it all too seriously.

As with any political figure and the governor of the Bank of England is a political figure, make no mistake you can't just take King's words at face value.

The Budget is coming up next week. Osborne is under a great deal of pressure to persuade the country that his strategy is working. The last thing he needs is to stand up on Wednesday, against a backdrop of a panicky, plunging pound, and a Bank of England that seems in disarray.

He needs all the help he can get. So it's nice to have a heavyweight like King throwing his weight behind the austerity' plan. Particularly as it seems that Osborne's biggest idea will involve some sort of relaxing of the Bank of England's inflation target.

This might seem cynical. But if King really has decided that the British economy is on the road to recovery, he must have changed his mind pretty quickly. A few months ago he was all in favour of more quantitative easing. And given how bad the recent economic data has been, it's hard to see what could have changed his mind.

So I'd say this is more a little jawboning' to help the chancellor out before his big day.

The truth about the pound rally

So why has the pound rebounded? The simple answer is it was due a rebound. Nothing goes down in a straight line, although sterling has made a heck of a good attempt at it over the last couple of weeks.

As Jamie Chisholm pointed out in the FT earlier this week, the pound was starting to look oversold. According to Lloyds Bank: "Net GBP short positions are now in the top 2% of net short positions held in the history of the series." In other words, traders were almost as bearish as they could possibly get.

As any good contrarian investor knows, when everyone is betting on one outcome, chances are the opposite will happen. There are lots of sound reasons behind this.

If everyone is bearish, then there's no one left to sell. That means you don't need much in the way of good news to trigger a rally. Same goes for the other way around. If everyone is bullish, there's no one left to buy.

But in the longer run, once the oversold' condition is shaken off, I can see sterling falling further. The fundamentals haven't changed. If Osborne genuinely is relying on monetary policy to pull the economy out of a hole, then a weaker pound is a key plank of that strategy.

Central bankers don't want a disorderly' sell-off in their currencies of course. The 17th century French politician Jean-Baptiste Colbert famously said that: "The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing."

The art of inflating away debt inflation is a stealth tax after all is similar. You want a gentle drift lower, rather than a horrendous rout that hits the headlines and scares the horses. It's all part of the government's financial repression strategy.

So in short, keep making sure you diversify your portfolio beyond sterling. I made a few suggestions as to how here.

That said, I have to take my hat off to our spread betting expert John C Burford. In his free MoneyWeek Trader email on Wednesday, John took a look at the pound. He highlighted the fact that sentiment was so drastically against the UK currency, and argued the case for going long it's a bet that would have paid off. John also suggests a target for where the pound could bounce to. If trading currencies is something you're interested in, you can sign up for his email here.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.