The sterling seems set to strengthen. At least against the Euro. That is the message that macro-economic fundamentals are giving us right now: robust Retail Sales figures, higher than expected core inflation, and rapidly reviving housing markets, the latest in a string of stronger than expected data.
There now seems little prospect that the new Bank of England Governor, Mark Carney, will preside over any more quantitative easing or cuts in base rates after he takes the helm in July. Indeed the sterling interest rate futures markets have already started to anticipate rises in rates, with the first 0.5 per cent hike now expected as early as the end of next year.
Short-term interest rates can be an important determinant of exchange rates; especially when the differential between the two rates involved changes rapidly, and one finds it hard to envisage a rise in Euro rates any time soon. Indeed, we are lead to believe that debate continues to rage within the European Central Bank as to whether they should take their deposit rate into negative territory.
I personally do not expect that to happen, principally because of the “locomotive effect” from an American recovery which is gathering pace by the day. The UK also stands to benefit from this effect, but much more so given the absence of the idiosyncratic challenges which face the Eurozone, in the shape of extreme imbalances between regions, ongoing steroidal austerity and the ever present threat of violent social unrest this summer as tragic levels of unemployment drive voters onto the streets.
The UK’s flexible labour market also places us in a much better position to expand. The foreign exchange markets have a knack of moving very rapidly to discount these sorts of changes in prospect for both the economy and interest rates.
If this move in sterling went too far, however, the new Governor may start protesting. He may well see the tightening in monetary conditions that this would imply, as too much, too early for a still nascent recover. However, the foreign exchange markets can move a long way, and very quickly, before he settles into his seat next month.