Sterling’s strength doesn’t mean the economy is back in rude health

Foreign exchange traders have their own arcane vernacular. Amid references to “loonies” (Canadian dollars), “gopher” (the American dollar/yen pair) and “Barney” (for the US dollar/ruble), you’ll hear plenty of chatter about “cable” — slang for the British pound/US dollar currency pair, drawing its name from the 1800s when the exchange rate was communicated via a copper telegraph cable beneath the Atlantic.

Don’t worry, this isn’t a guided tour of the peculiar lingo adopted by the City’s FX clique. Rather, besides their strange terminology, I’d like to probe another aspect of the currency markets that some might find odd — namely, that sterling has recently been one of the best performers. Surely a surging pound is incongruous with the government’s metamorphosis of late into a giant sad-face emoji?

In fact, sterling is up about 3 per cent versus both the US dollar and euro since the beginning of the year, hitting a two-year high just over a week ago. Strategists at the big banks are busy talking up its prospects for the near future.

Last week, Bank of America predicted that cable would hit a four-year high of $1.41 by the end next year, with Goldman Sachs also forecasting that sterling’s momentum against the dollar should continue.

As we approach Labour’s flagship “global investment summit” next month, followed by the autumn budget a fortnight later, we might well see political efforts to cast the strengthening pound as a vote of confidence in the new government from international investors. After all, the value of a currency is usually considered a good barometer of economic health.

There would certainly be some truth to this narrative. Key UK economic data suggests we are moving away from the perma-stagnation of recent years. If Bank of America’s projection of $1.41 turns out to be accurate, we will be heading back towards pre-Brexit valuations — halcyon days when a shopping trip to the US didn’t necessitate having to sell your house.

The last time we hit this level was May 2021. The pound briefly leapt at the prospect of the Covid lockdowns ending, but faded inexorably until its nadir during Liz Truss’s short premiership.

Nevertheless, if I were Rachel Reeves, I’d be careful not to overplay the currency card.

First, it’s a gargantuan exaggeration to conclude that sterling’s hot streak stems purely from a UK economic rebound. The reality is that it has more to do with recent dollar weakness and American monetary policy. Following a surprisingly weak jobs report last month, the US Federal Reserve appeared somewhat alarmed and signalled that it wouldn’t tolerate any further weakening in labour market conditions — meaning that investors expect a slew of aggressive interest rate cuts.

By contrast, they think the Bank of England will take a gradual approach, given its insistence that the spectre of high inflation has not yet been exorcised amid relatively solid economic data. This gentler downward slope for rates implies that sterling could be one of the highest yielding of the major currencies.

In essence, it’s a see-saw effect: the Fed’s hardline path is pushing the dollar down and, in tandem, the pound up.

Second, a buoyant currency could hurt the FTSE 100, just at the point when global investors are acquiring more of a taste for UK stocks. The UK’s largest companies make about 80 per cent of their revenues internationally, so stronger dollars and euros translate into higher earnings when converted back into sterling. Conversely, a higher sterling to dollar rate gives UK companies, quite literally, less bang for their buck. Although FTSE 250 companies are often said to be “more domestically focused”, their revenues have quietly become much more global in recent years, with 57 per cent generated overseas — so many mid-caps will feel the pinch too.

Sterling’s revival owes more to the expected actions of the Fed (plus the political turmoil in France and Germany weighing on the euro) than economic turnaround measures under way in the UK. If the government decides that “a win’s a win” and uses a stronger pound as a key indicator of progress, it will need a lot of other proof points to convince investors.

It’s too big a stretch to say that sterling’s position at the top of the currency leaderboard is a pyrrhic victory — but it is a red herring as a proxy for economic health.

Seema Shah is chief global strategist at Principal Asset Management