The dangers of the strong pound

Last week's inflation shock propelled sterling through the symbolic $2 mark for the first time since 1992 and on to a 26-year high of $2.01. Inflation raises the prospect of higher interest rates and at this stage, as Jeremy Warner says in The Independent, "the main factor putting a rocket under the pound" is that higher rates boost the yield on UK assets. The market has pencilled in two more quarter-point hikes and there is now talk of a 6% base rate. The US, conversely, is one of the few countries where rates are expected to ease. This has sent the greenback to near-record lows against the euro.

Britain will soon have the highest rates in the G7, says Mark O'Sullivan in

The Sunday Times. High rates have made sterling attractive to carry traders and central banks: China, Brazil and Russia are among the countries that have been diversifying reserves into sterling. The pound now accounts for a "staggering" 12% of foreign deposits held by world governments, says Ambrose Evans-Pritchard in The Daily Telegraph. Given all this, it's no wonder some currency analysts see scope for a rise to $2.10 over the next few months.

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But how long can sterling stay above $2? The main long-term influence on a currency is the current account, and here, the news isn't good. Britain's current-account deficit of just under 4% is flattered by a surplus on investment income: UK firms earn more on their foreign investments than vice versa. But this surplus is declining, says HSBC. The "worsening current-account profile" may not matter now with the markets focused on yield, but if global risk-aversion rises, or the UK shows "strong evidence of slowing", the current account will take centre stage, says HSBC.

With the pound looking set to remain strong, the dollar currently weak and rates set to rise, the outlook for the corporate sector and the market is clouding over. A strong pound and weak dollar increases the price of British-made goods abroad and lowers sterling earnings for firms with operations in the US; about a third of FTSE 350 sales are sensitive to dollar movements. According to Citigroup, the impact of a weaker dollar on the broad UK market is likely to be "modest at best". Over the past 26 years, there has been no meaningful relationship between dollar weakness and UK stock prices. But there is an impact on some stocks: during the past six months, those with no dollar exposure have risen by 2% more than those with over 50% of their sales in dollars. Mega-caps, pharmas and industrials have the highest exposure to North America. Some blue chips (including BP and HSBC) pay dividends in dollars, which will be worth less in sterling terms.

But a more serious problem for the market is the domestic impact of rising interest rates. As Liam Halligan points out in The Sunday Telegraph, with consumers already shelling out 20% of their incomes on servicing their record debts, another rate hike "will cause real pain". And if Professor Tim Congdon of the London Business School is right to say rates could hit 7.5% over the next two years to cool inflation, it will be truly painful.

As Morgan Stanley's Graham Secker notes, 70% of UK mortgages are now fixed-rate, compared to 20% in 2002. Most of these fix the rate for two years, so many homeowners face a jump in payments; this cycle is "likely to bite" in the second half of the year. Higher rates bode ill for banks, housebuilders, and especially retailers, says Chris Brown-Humes in the FT. Add the fact that stocks are now "expensive", on a median p/e of 18, and the fundamentals for equities are "quite poor", says Secker. Only a "fickle" flow of mergers and acquisitions money is propping up this bull market.