Which will crack first - the pound or the dollar?

The $2 pound is back. It took a while - in fact, the pound hasn't been at these dizzy heights in about 26 years, but at last we can snatch up all the 50p dollars we want, high-tail it to the States, and gorge ourselves on bargains.

But how long will it last for and why have we hit this level again after all this time? There is no easy answer to either of those questions but let's have a go at it anyway.

There are lots of reasons behind sterling breaching the $2 mark. Most obviously, inflation just took off in a very visible way in the UK (though of course, as regular readers know, it's been on the way up for a long time). Bank of England governor Mervyn King's letter to the chancellor seems to have finally brought the City's attention to the fact that inflation is a problem in this country, which means that the market now expects further interest rate rises.

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Meanwhile, the housing market is still roaring away while economic growth figures have been strong enough to keep a smile on even Gordon Brown's face.

Pound vs. dollar: diverging interest rates

On the other hand, despite persistent inflationary fears in the US, the market generally still expects the next move to be a rate cut over there, particularly in light of the crumbling housing market. This may be wrong there are similar inflationary forces such as rising food prices and more costly energy bills in the US - but it's expectation that counts in this case.

Currently, the base rate in both countries is 5.25%. However, rates in the UK look set to climb, while in the US they look set to fall. That means that carry traders (who borrow money in a low interest rate currency like Japanese yen, and make money by investing in a higher interest rate currency) are more interested in buying sterling where they can get a higher yield on their money, than dollars.

So it seems to make sense that sterling is rising so strongly against the dollar.

But of course, there's more to it than that. If you look at the UK and the US, they in fact have an awful lot in common with one another - and not much of it is good.

Pound vs. dollar: the debt issue

Consumer debt is a huge issue in both countries the US consumer seems to have cracked first, with overenthusiastic lending to bad credit risks eating away at the country's housing market. But the UK consumer also looks very vulnerable a £1.3 trillion debt mountain is not what you want to be sitting on while interest rates are rising.

Not only that, but public borrowing on both the US and the UK is also huge. As Martin Hutchinson points out on Breakingviews, over time, the current account position should matter most. The current account basically measures how much money is coming into a country, and how much is going out. Just like a typical household, if a country runs at a deficit for too long, people start to worry about how it will make good on its debts, and stop buying its currency, driving the currency lower.

The US deficit racks up at about 6% of GDP. To put that into perspective, most economists reckon that at about 4% or so you're starting to get into banana republic' territory. Meanwhile, the UK also has a significant deficit last year the current account deficit was £43.4 billion, the largest on record, and equal to 3.4% of GDP.

Pound vs. dollar: foreign investment and financial services

What props America up is the willingness of foreigners to fund its massive deficit by buying dollars. Basically, countries like Japan and China buy lots of dollars to keep their own currencies weak, enabling American consumers to keep buying their exports. As for the UK, what's propping our deficit up is the global boom in financial services, which centres largely on London (much to the chagrin of its rivals in New York).

Neither of these situations can last forever. If US interest rates do head lower, and the dollar keeps weakening, foreigners will not want to keep buying dollars. That would send the US currency even lower.

But the same goes for the global financial boom. The merger and acquisition frenzy, the private equity boom, the hedge fund industry all have been propped up by low interest rates, which has driven a flow of cheap money looking for a home. With global interest rates rising, that flood of money could well dry up which is bad news for the financial services boom.

So in reality, both sterling and the dollar look vulnerable, and it's a tough call as to which will crack first.

Pound vs. dollar: seek alternatives

But if that's the case, then where should you be investing your money? Well, at MoneyWeek, we're keen on Japan, where the economy looks like it should recover. By buying Japanese stocks, you can gain some exposure to the yen, which is historically low against the dollar at the moment. Alternatively, you could look at Germany - the euro is strong, but interest rates keep rising, and the Germany economy is recovering very well.

But currencies are volatile, and while we like both Japan and Germany's economic prospects, we wouldn't be betting on the money they print. If you're looking for a solid bet in a world of unstable paper money, you need to go back to a tried and tested currency that has lasted millennia without being destroyed by rampant inflation - gold.

The yellow metal traditionally rises as the dollar weakens, and is also good at protecting your wealth from inflation. Many experts believe that everyone should have about 10% of their portfolio invested in gold, and there are many ways to gain exposure. One of the easiest (and more convenient than buying physical gold) is to invest via a financial instrument that tracks the price of gold Lyxor Gold Bullion Securities (GBS) is one such security listed on the London Stock Exchange.

First published on MSN Money (27/4/07)