By Matthew Lynn, Bloomberg
You need to be at least 40 to remember when the pound regularly traded at more than $2.
It broke through that point last week for the first time since the UK was thrown out of the European exchange-rate mechanism in 1992.
Most people view a $2 pound as a historical aberration and assume it is about to slide again, just as it has in the past.
Think again. The British currency may go even higher -- perhaps to $2.50.
“There are a lot of good reasons to think it will carry on,” Peter Dixon, London-based global equities economist at Commerzbank AG, said in a telephone interview. “The carry trade has been boosting it, and it’s hard to argue we will see an end to that soon because the Bank of England will continue to raise rates. There is momentum behind sterling right now.”
The pound’s value against the dollar is at its highest in a quarter of a century. It touched $2.0133 last week, the strongest it has been since June 1981, when Margaret Thatcher was a relatively new prime minister and the British economy was still the sick man of Europe.
History tells us that when the pound reaches those levels, it soon collapses. After climbing to $2.44 in 1980, it slumped to $1.05 by 1985. Then after breaking through $2 in 1992, it dropped back to $1.41 the following year.
So a $2 pound is quickly reversed? Maybe not. There are five reasons to think it will go a lot higher.
The UK has serious inflation. Prices rose 3.1% in March, much more than the Bank of England’s 2 % target. For the first time, the bank’s governor, Mervyn King, had to write an open letter to Chancellor Gordon Brown explaining why it was above the limit. Interest rates will have to increase to bring that under control, which will keep money flowing into the UK.
In a perfect world, the government would curb its own spending and borrowing to help tame inflation. There is zero chance of that happening with Brown, who is expected to take over as prime minister from Tony Blair later this year. So the central bank will have to control inflation by itself -- another reason rates will go higher than most people expect.
Sterling is continuing to grow in strength as a reserve currency. Central banks bought $36.2 billion of reserves in pounds in the four quarters ended September 2006, according to data compiled by the IMF. It is now the third-most-important of the world’s reserve currencies.
“The boost to sterling from central-bank buying has gone on, and shows no signs of stopping,” Michael Saunders, London- based chief Western European economist at Citigroup Inc., said in a telephone interview. “There is still rapid growth in exchange reserves around the world. And central banks should be holding more of their reserves in sterling than they currently do.”
Central banks won’t be looking at trade data or growth rates. They will see that the UK has higher interest rates than most major developed economies, and keep buying the currency.
Next, with the US housing market looking soggy and the economy weakening, the Federal Reserve is more likely to cut interest rates from their current 5.25 %, the same level as in the UK. Yet with the Fed likely to cut rates, and the Bank of England raising them, a gap will open again. That will be another incentive for investors to sell dollars and buy sterling.
Meanwhile, London continues to extend its power as the world’s richest financial centre. That is bringing more money into the country, boosting the currency.
The UK had a record current-account deficit of 12.7 billion pounds ($25.4 billion) in the fourth quarter. That was 3.8% of gross domestic product, easily financed by the international investment flowing into the UK.
That makes five reasons to expect the currency to appreciate -- and only one against.
“$2.10 is not out of the question,” Dixon said. “But it is not something we would want to extrapolate more than three to six months out.”
The biggest threat to the UK’s current economic prosperity is a collapse of the pound. Britain is so dependent on imports, the Bank of England would have to push interest rates much higher to defend the currency, thus tipping the domestic economy into recession. If it didn’t, inflation would soar because the price of everything that the UK imports would be more expensive.
The momentum for now is up, and is likely to remain that way. The days when a $2 pound was followed by a sharp fall are now in the past.