Sterling To Resume Downtrend

Figure 1. UK - Sterling's Real Trade Weighted Exchange Rate, 1970-Oct 98 (Index, Average 1970-97 = 100)

Sterling Remains Overvalued and Vulnerable to Slippage

Sterling's Real Exchange Rate Remains Far Above Long-Run Norm ...

Even after its recent slide, sterling remains significantly overvalued versus other industrial countries. We estimate that, at about DM2.80/163, the pound's real trade-unions weighted exchange rate is 10%-11% above its long-run average (1970-97), and about 5% above the average seen during the UK's membership of the ERM. The pound's real value is near its long-run norm against the Deutschemark, but about 9% overvalued versus the euro area as a whole. The pound's real value is about 50% overvalued versus the Australian and Canadian currencies, 30%-40% overvalued versus the Swedish Krona, 20%-30% overvalued against the New Zealand dollar, and about 16% above its norm versus the US dollar. The pound's full overvaluation probably is greater than our estimate, because our figures just use the main industrial countries and do not allow for the pound's rise versus emerging market currencies.

... And Causing Dramatic Export Squeeze

The scale of sterling's overvaluation is evident in the plunge in UK export orders, which are near the lows of the past 20 years, in contrast to the stronger trend in the euro-area. Exports from both the UK and euro-area countries to emerging markets are weak, but the high pound is causing a huge extra squeeze on UK exporters.

Figure 2. UK and Euro Area -- Export Orders (Diffusion Indices), 1978-98

Note: Chart shows the balance of companies that report export orders are above/below normal. Sources: Eurostat and Salomon Smith Barney.

Slowing UK Economy Will Erode Pound's Interest Rate Cushion ...

Of course, currencies often stay overvalued for a while. However, earlier periods of a very high pound have ended once base rates start to trend down (e.g. in 1981 and 1992), and the slowing UK economy implies that this stage is here again. Unless sterling falls very quickly, then it is a question of when, not if, rates fall again. The MPC's statement that accompanied the rate cut referred to weakness in surveys and reports from the Bank of England's regional agents as key factors behind the move. Rates probably will fall again in the next few months, and perhaps in November if external conditions worsen or the upcoming surveys from the British Chambers of Commerce and CBI are weak.

... While US dollar is losing its lustre

Moreover, the US dollar is likely to dive again versus euro-area currencies on anticipation of further cuts in US short rates. The high correlation between the US and UK currencies in recent years implies that a weak dollar will also undermine sterling.

Some Might Argue That EMU Convergence Will Limit Pound's Downside ...

One factor that might limit sterling's downside is a general consensus that the UK will join EMU at around DM2.50-2.70/163. A DM2.50/163 level, with the current mix of other exchange rates, would put the pound's real trade-unions weighted value versus the euro area near its long-run norm. At present, markets project that the pound will fall just below DM2.50/163 in six years. If market expectations solidify on EMU entry in 2002-03 at DM2.50-2.70/163, then sterling is unlikely to fall significantly nearterm unless the gilt-bund spread also falls -- in other words if the UK-German short rate spread falls more quickly than already is priced in. In effect, EMU expectations would anchor sterling's spot value via the DM2.50-2.70/163 forward rate and the gilt-bund spread.

Figure 3. UK -- DM/163 Six Year Forward Exchange Rate, 1997-98

Source: Salomon Smith Barney.

... But EMU Convergence Floor May Not Hold Given Uncertainties About Entry Date and Rate ...

However, the EMU floor may not hold. First, it is not certain that the UK will actually join EMU in 2002-03. Public opinion currently is still somewhat against EMU and, if this persists, then this EMU convergence argument has less significance (see pages 4 and 5 for an update on public attitudes to EMU). Second, it is not definite that the pound's entry level will actually be around DM2.50/163-2.70/163. The entry level will have to be agreed unanimously by EMU members, although the UK probably will aim to secure an earlier informal agreement with the German and French authorities. It is possible that the constellation of other exchange rates at that stage is such that a DM2.50-2.70/163 level will seem significantly too high, or too low, for the UK. Finally, in the current risk averse conditions, many investors may be unwilling to rely on such relative valuation factors unless there is a big gap between the pound's forward rate and its likely EMU entry rate.

... and Low Forward Levels of Danish and Swedish Exchange Rates

The experience of Denmark and Sweden -- the other EMU outs -- also counts against over-reliance on the EMU convergence factor. The forward exchange rates of the Danish and Swedish currencies in five-six years are well below their likely EMU entry rates of DKr3.81/DM (Denmark's bilateral central rate) and about SKr4.30/DM, and would put both countries' real exchange rates well below their historic norms in real terms versus the euro area. However, the chances of those two countries joining EMU in 2002-03 are at least as high as the UK's. Thus, investors who believe that the EMU convergence argument will support sterling versus euro area currencies might consider underweighting sterling and overweighting the Swedish and Danish currencies, on the view that those two countries will join EMU at levels that are well above those implied by forwards.

EMU Sentiment Little Changed, But Remains Less Hostile Than A Year Ago

EMU Support Edges Down, But Remains Up From A Year Ago

Our latest poll shows a slight rise in hostility to EMU since July, although the balance of opinion against EMU remains well down from 1996-97. On our first question ('How would you vote?') the balance of opinion against EMU edged up to 19% from July's record low of 17% - although this compares to 27% last October, before the Government's statement in favour of the principle of EMU entry. On the second question, which tracks EMU sentiment in the context of a strong pro-EMU line from the Government, the balance of opinion against EMU stayed at 7%, matching July's figure which was the lowest since MORI started asking this question in late 1997.

Figure 4. UK -- Question 1. If There Were a Referendum Now on Whether Britain Should Be Part of A Single European Currency, How Would You Vote? Oct 97-Sep 98

Latest survey was carried out between 24 -30 September 1998. Sample size 1,942 people. Note: Sample sizes are for September 1998, but are similar for earlier results. Numbers may not sum because of rounding. Sources: MORI Financial Services and Salomon Smith Barney.

Weak Economy May be Prompting Pro EMU Shift Among High Income Groups

The split shows a clear pro-EMU shift since May among Conservative voters, the high-income AB social group and readers of the quality press. This may be linked to the recent dive in confidence in the economy's prospects, with some people seeing gains in the lower interest rate level and faster growth prospects ofeuro-area countries.

Tabloid Readership Remain Strongly Anti EMU

Readers of the tabloid press, who outnumber the readers of the quality press by more than three to one, remain more hostile to EMU and have become slightly more hostile since July. Among readers of the tabloid press, there has been a clear pro-EMU trend among the readers of the Daily Express and Daily Mirror, both of which are strongly pro-Labour papers. However, the readers of the conservative-leaning Daily Mail remain more hostile, while the readers of The Sun remain very anti-EMU.

Figure 5. UK -- Question 2: If the Government Were to Strongly Urge That Britain Should Be Part of a Single European Currency, How Would You Vote? Nov 97-Sep 98

Inverse Correlation Between EMU Sentiment and Support for Labour ...

It is still not clear if public opinion will shift enough to allow an EMU referendum in 2003-03. Our polls highlight the extent to which attitudes to EMU cut across party boundaries, so that a sizeable number of people back a party even though they are out of line with its policy on EMU. For example, taking all of this year's polls together, in order to smooth our monthly fluctuations, there is a clear inverse correlation across social groups between EMU sentiment (strongest in the high-income AB social group and weakest in the low income C2 and DE social groups) and support for Labour (weaker in the ABs, strongest among the C2s and DEs). Roughly 40% of those would support Labour would oppose EMU entry even if the Government urges a 'Yes' vote (question 2). Similarly, despite their strongly anti-EMU stance, 50% of readers of The Sun would vote Labour, with just 18% backing the Conservatives.

Figure 6. UK - Public Attitudes to EMU and Political Support for Labour, Average Over Jan -Sep 1998

Sources: MORI and Salomon Smith Barney.

... Which Raises Sizeable Political Challenges for Both Labour and The Conservatives

The challenge for Labour and the Liberals is to keep this anti-EMU support even while the election date -- and the Government's stated aim of EMU entry soon after the next election -- come closer. The Tories' challenge is to keep their pro-EMU wing (just over a fifth of conservative voters favour EMU entry), and to broaden their support into the rest of the population, which currently is less anti-EMU than the Tory's core support.