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Britain: Back in black?

07 September 2010 Written by 

August 2010

As the global economic pick-up trudges along like a dazed hobo, price pressures abound and uncertainty reins. Meanwhile, Britain is practically willing its own recovery with a strengthening pound, healthy first-half bank profits and slow but sure economic growth...

In August, Britain saw its strongest quarterly economic growth figures for four years. The figures were twice as good as expected.

And lending figures from major banks to small businesses, though still in a "heartbreaking" situation, according to Bank of England governor Mervyn King are none-the-less nothing like as bad as we had feared this time a year ago.

With investors' confidence additionally buoyed by banks passing the euro zone stress tests, the pound just hit a six-month high against the greenback, with its upwards momentum going some way to ease fears of a double dip recession in the UK.

Not so for the US, where the dollar is continuing to take a royal kicking from sterling and the euro, which remains in a rally that's seen it gain 10% since June. What's more, bets against the dollar appear to be picking up speed.

But maintaining this growth in Britain is about to be sorely tested by fiscal austerity measures, threatening the euro zoneís biggest public spending cuts for decades.

At home, former chancellor Alistair Darling thinks the coalition's planned spending cuts will halt the economic rebound while Chancellor George Osborne thinks all of this positive news means the economy is ready to bear the burden of his proposed cuts.

Meanwhile, Germany's austerity package is being restrained by opposition in its lower house, allowing Europe's single biggest economy to make further gains, which is just as well because Europeís number two economy, France, is showing activity falling to an 11-month low.

Despite the improvement in the value of the pound since the spring, it is still trading at a level around 18% lower than its dollar value in 2008. On the plus side, this is great news for exporters to the US. The government and the Bank of England expect the weakness in the pound to continue helping to improve this balance of trade and support the recovery well into next year.

Traders meanwhile have been switching to the European currencies, which are normally considered more risky, as Jean-Claude Trichet the European Central Bank president holds his opinion that growth in Europe will be "moderate and uneven".

In this respect, sterling's gains may well be more to do with the carry trade than any fundamental improvement in the economy. This involves investors borrowing in a currency in which interest rates are low to buy a higher-yielding one, or one where assets are appreciating.

Since worries subsided about Greece going bankrupt, the summer has seen a boom in the carry trade, with the dollar used as finance. Hence the dollar is down and other currencies are up. But we can expect this to reverse at the first sign of economic volatility. And August, being a holiday month when trading is weak, is prime territory for a bit of volatility.

Besides, as a result of carry trade activity, forex market insiders think that both the pound and the euro are overvalued, and the dollar undervalued, on a purchasing power parity basis.

Any bad economic news could see the pound slide as carry traders rush to unwind their positions.

Traders eyes now will move to the US where the question of monetary policy hangs in the balance. Alan Greenspan, former Federal Reserve chairman, said recently that the economy is "very distorted", heavily relying on a manufacturing rebound, and otherwise "on pause" at the moment.

But as I write, a positive US manufacturing purchasing managers' index of activity is being hailed by some as an indicator that the US economy is recovering. As a result, bears are turning into bulls and taking bigger currency risks.

Yet even with banks potentially on better footing, investors are behaving as if the global economy still has a long way to go, and they should do.

Mervyn King has warned that there is "still some considerable distance to travel". Despite this, weíre undoubtedly in the midst of a bounce back from the most severe recession since the Second World War.

The concern now is when the bounce will end and what will happen thereafter. It seems likely weíre headed for another fall at the end of the year, where growth could slow to a trickle ñ and then what will us traders do? After all, we only make money when prices go up or down!

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