For the first time in four years, the British consumer has under-spent his or her continental counterpart ending an enviable string. This period of out-performance dates from the ignominious collapse of the pound in September 1992. Although this was seen as a disaster at the time, the British economy shrugged off the supposed inflationary impact and began a boom that has been the envy of Europe for the past ten years. The fallout from the devaluation pushed the Conservatives and John Major from power while the following good times have made Tony Blair an economic magician. One of the more impressive results of the “Black Wednesday” collapse was the loosening of the monetary purse strings leading to the enrichment of London as a financial center, an equity market boom, and the rebirth of the real estate boom.

Over the past 12½ years, the economy has been the beneficiary of a gigantic re-basing of interest rates. While Short Sterling rates generally ranged between 9% and 14% in the period between 1980 and 1992, in the past five years the range has been roughly 3½ % to 6%. Britain was doubly lucky as not only did it devalue in 1992, since as a result of the politics around that move, it did not abide by the Maastricht criteria, the pact whose strictures eliminated almost all of the benefits gained by the Italians, Finns, and the other countries that also devalued in 1992. The rising tide of liquidity lifted all British boats. In fact, these were not the only reasons for the British success. Added factors must include the trade union reform that Blair inherited from Thatcher, deregulation in many fields, lax immigration policies, and globalization. The dynamic Southeast of England is a far different place today than it was as recently as 1980 –and this is not a factor of lower interest rates and bountiful liquidity.

The recent slowing of the British economy can be traced to the tightening, which began in November 2003 when the Bank of England moved the base rate from 3.50% to 3.75%. Rates peaked in August of last year at 4.75%. Eventually this impacted the housing market and personal consumption, dropping the economy to its current 2%+ level, slightly above the EU average. Could this be the end of England’s stellar performance?

The latest news that the Bank had voted by the narrowest of margins, 5-4, to maintain its 4.75% rate at its last MPC meeting in early July, Is enough to convince us that Britain will continue to outperform Europe. An activist central bank that is watching more than the inflation rate, but also the employment situation, final sales, and the economy in general will almost always have a higher nominal output than one that watches inflation alone. The risk of this activist stance is that inflation will take a larger cut out of nominal growth. The activist bank must also be poised to take the punch bowl away, but those of us in the FX market are not certain that this will be the case. As a result, Sterling is under pressure for two reasons: lower rates today and possibly higher inflation tomorrow. Although quick action will probably save the economy and give growth a new push, the pound will probably suffer from this effort. And once again, a weaker Sterling will act as a further stimulant to growth in the months ahead.

And the US Dollar?

One of the critical questions we must ask is: How much further will the dollar rally? We know that the dollar moves higher as the short-term interest rate differential between the US and other currencies increases, but only after a lag of 12 to 15 months.

The interest rate spread began to widen in favor of the dollar in April 2004, but only at the start of 2005 did this spread surpass the 1.00% area.

The spread is likely to be a positive influence for the dollar for many, many more months. One of the other interest rate indicators pointing to a strong dollar is the slope of the dollar yield curve. On the bottom of the chart below, we illustrate the spread between the three-month and the 30-year points on the US curve. Historically, the flatter the curve the stronger the dollar will be, which also points to a strong dollar for many months ahead.

The first indicator of the dollar’s next decline should be the Bond market. As the dollar strengthens, the curve flattens, and the Bond market eventually begins to rally. Historically, this Bond move usually lags the dollar upmove by about 15 months. If that is the case, the Bond market should turn up in the first quarter of 2006.

At first this will further invert the yield curve, but then it will cause the Fed to cut rates, usually with a lag of 6 to 9 months from the inversion. As there is a further lag of around 12 months before the lower rates impact the dollar, at this point we can’t predict a major dollar decline before mid-2007.

The Oil Conundrum

Try this on for size: Commercial crude-oil inventories are nearly 8% higher than a year ago, while world demand has slowed to a projected 2.2% this year from 3.4% in 2004, and the U.S. government has effectively stopped stockpiling emergency oil reserves. Yet, oil prices are 60% higher than they were a year ago.

Though oil prices have retreated somewhat from their record high of $60.54 a barrel, one analyst thinks that based on the fundamentals, prices should be lower than the $35.50 a barrel crude fetched at this time last year. “If you throw enough money at a market, you can move it,” says Tim Evans, senior energy analyst at Thomson IFR Markets. Another way to put it: “If the wind blows hard enough, even turkeys can fly, and when you look at the DOE statistics, crude oil looks like a turkey.”

Evans maintains that the market’s short-term orientation, evidenced by the frenzied futures-contract trading, is out of touch with what’s happening in the physical market. “This is a market that is basically in denial about how generous physical supplies of oil really are,” he says. While supply is rising normally, consumption is growing by a smaller amount, even with China and India part of the scenario.

“There’s talk in the market that high oil prices have not yet reached a point where consumers are doing anything about it,” he says. But the longer-term picture tells a different story. Evans points to a 19% drop in sales of big SUVs by GM and Ford so far this year.

Evans views the recent 5% drop in prices as at least as significant a turn as that in early April, when crude fell to $46.20 from $58.20. “Prices could be $30,” he says. That makes more economic sense than $60.”

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