19 May 2000

Ups and downs of currency prediction

The alarming fall in the value of the k

since its launch in Jan 1999 has had a

massive impact on UK farm incomes. But,

after touching record lows recently, the

new currency has staged a modest

recovery. Is it sustainable? asks Europe

editor, Philip Clarke

TRYING to predict future currency movements is a mugs game; just 18 months ago, in the run-up to the launch of the k, the most respected industry pundits were saying the £ was ridiculously over-valued and had just one way to go – down.

At that time, sterling was trading at the "dizzy heights" of £1=2.8 Deutschmarks. In a year or two it would be down to 2.5DM, they said, at which point it may well be worth joining the single currency.

Recent history shows how wrong they were, as the £ has continued to soar, reaching a 14-year high of 3.4DM at the start of this month.

Of course, the Deutschmark is now inextricably linked to the k and it is movements in that currency which everyone is watching. The 20% slide in its value since the Jan 1, 1999 launch has taken a heavy toll on UK farm balance-sheets.

But a couple of weeks ago farmers weekly made the rash observation that "what goes down must surely come up". A statement of the obvious or a prediction based on sound economic analysis?

Certainly the k has recaptured some of its previous value over the past two weeks, inching its way back to over 60p from a low of 57p. That does not constitute a trend. But for some time now, analysts have been saying that the ks weakness is not justified by the economic fundamentals.

Growth in the euro-zone, while not as strong as in the US, is considerably better than in the UK at 3.4% a year. Mainland Europe also benefits from lower inflation than in the US – currently running at 2.1% against 3.7% – while labour is up to 25% cheaper.

Economic indicators also suggest the US economy is in danger of over-heating, with higher wages fuelling domestic demand. The expected response is for the government to push interest rates higher. Initially this will lend support to the $ over the k. But sooner or later it will lead to a squeeze on company profits and a downturn in share and currency values.

Despite these trends, currency traders have continued to eschew the k. They have been driven more by sentiment, perceiving the European Central Bank as weak, while arguing that the "one interest rate fits all" policy cannot work for 11 diverging economies.

But sentiments can change and there is a view that the ECB has not been doing such a bad job. Despite the ks slide, the bank has restricted itself to modest rises in interest rates, (to 3.75%), enough to offer some support, but not enough to stifle economic growth.

Closer to home – and critical for the UK – is the value of the £. Again, the news is somewhat more positive. As the UK economy slows – first-quarter growth was just 0.4% – there is a growing consensus that interest rates may have peaked, with inflation under control.

Hopefully, all this points to a narrowing of the crippling exchange-rate gap between the UK and the euro-zone.

The danger is, there is still a lot of negativity in the currency markets towards the k. Any rally in its value is likely to be short-lived as reluctant "long holders" seize the opportunity to sell their stocks.

But countering this is the possibility of the ECB stepping in to buy ks, stabilising the currency.

That is the prediction. What happens in practice, only time will tell. &#42