US dollar pain is the British pound's gain

Whilst the current dollar-pound exchange rate may be good news for Brits bringing cheap ipods back from New York, any American travelling to Europe is set for a battering - as Martin Denholm explains.

I just returned from a trip back home to England and my wallet has come staggering back with me, battered and bruised, after spending a week in the financial equivalent of one of those English rugby scrums, thanks to the strong British pound. Boy, what a beating!

For example, think U.S. gas prices are bad? (And with the national average price per gallon having just a hit a record $3.10, I wouldn't blame you). Consider this: Just a week ago, I pulled off the rain-soaked M6 motorway in my car to fill up. I had one-quarter of the tank left when I started. But by the time the beast was full, the price totaled £45. That's about $90!

Sure, most of that money gets plopped into the British government's coffers in taxes, but the fact is, you still have to pay it regardless of where it goes.My deflated dollar purchasing power isn't surprising, considering the British pound hit a 26-year high of $2.01 against the greenback on April 18, and is currently trading around $1.98.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

As a Brit, when I lived in England and visited America, a strong pound was great for me. But not any more. Today, the rate is downright awful for Americans traveling to England or continental Europe. In addition to the pound hitting a 26-year high, the dollar's downward slide recently culminated in the euro notching up a two-year high. The Australian dollar also soared to a 17-year high.

Many people look at this and wonder if it's because of dollar weakness, or strength abroad. With regard to the America-Europe currency relationship, it's a little of both. Let's take a look at two main drivers: Economic growth and inflation

Dollar-pound exchange rate: A Tale Of Two Economies

Over the past several years, both the U.S. and U.K. economies have performed pretty stoutly, with the strength reflected in the respective stock markets.

But despite the fact that corporate earnings results remain impressive and the stock market continues to plow ahead with gusto, some cracks are starting to appear in the U.S. economic growth picture.

For example, government figures showed that U.S. GDP growth crawled in at a 1.3% annual rate during the first quarter, down from 2.5% in the fourth quarter of 2006. It was the slowest pace in four years. And some economists think that number could yet be revised down below 1%.

This has led to speculation that the Federal Reserve may have to trim interest rates in order to maintain growth - a move that would dent the dollar, relative to places like Britain and the Eurozone, where interest rates are rising and making investments there more appealing.

And after several years of mediocre growth (and that's putting it politely), even the 13-nation Eurozone economy is finally expanding. First quarter GDP growth rolled in at 3.1% year-over-year, beating estimates that called for 2.9%. That led the European Central Bank to call for 'strong vigilance' to stave off inflation - a strong signal that interest rates are set to rise to 4% in June.

In Britain, however, GDP growth is still robust - and set to continue. The Bank of England says strength in the banking and communications sectors will help push growth to 3% this year - the fastest since 2004 - and projects the same in 2008.

But you don't have to look very far without stumbling across the dreaded 'I' word: Inflation

Dollar-pound exchange rate: Britain's Dose Of Inflation

Coming on the same day that British Prime Minister Tony Blair finally announced that he'll be leaving office, the news didn't receive as much attention as usual. But across town in London, the Bank of England made an announcement of its own: Interest rates would rise by another 0.25% to 5.5%. It was the fourth rate hike since August 2006.

And the main reason for the move? Inflation.

Britain's solid economy has resulted in strong employment growth. Unemployment just dropped to the lowest level since October 2005, with 31.6 million people now in work. Good news, for sure. But that's also causing inflation to tick up. Average earnings climbed 4.5% during the first quarter, with total wage inflation rising to 3.7%.

In turn, that means the overall inflation rate has jumped to 2.8% well above the bank's 2% target. In response, Bank of England governor Mervyn King has signaled that interest rates will likely have to rise to curb inflation, stating that the bank will do 'whatever it takes' to bring it back down to the 2% level.

Economists agree. The rate on September interest rate futures contract is currently trading around 5.9%. When rates do rise, the pound should receive a further boost, and you could see more money flowing away from dollar-denominated investments to more attractive U.K. investments instead.

By contrast, the U.S. inflation rate is relatively benign, with consumer prices rising just 0.4% in April from 0.6% in March. Core inflation (which excludes energy and food prices) rose just 0.2%. With inflation in check, the Federal Reserve hasn't had to touch interest rates for almost a year. That, coupled with a slowing economy that may yet need a Fed rate hike to prop it up, hasn't enticed investors towards the dollar.

A 'Three-Month Window' For Rate Hikes

There are other factors that have contributed to the dollar's slide against the pound and euro. For example, the U.S. is still running enormous deficits.

Energy prices have also sent inflation higher in Britain, with Mervyn King underlining the impact in a recent letter to the British government (one that was required once the inflation rate hit 3% in March). That's a major reason why the Bank of England has raised interest rates recently, which has helped the pound.

And although the bank expects energy price inflation to decline sharply over the course of the year, it states, 'The overall path of CPI inflation depends on what happens to other prices.' And the fact that inflation is already so high means interest rates should rise again in the coming months, as the bank strives to get inflation back to its 2% target rate.

Bear Stearns says there is a 'three-month window' for further hikes, so if you're looking to speculate and grab higher yields, now might be a good time to cash in on British inflationary pressures, rising interest rates, and continuing strength for the pound.

By Martin Denholm, Managing Editor, Mt.Vernon Research for the Smart Options Report,