Call it wacky, but sterling is on target for a classic market error

Everyone knows that markets make mistakes. You can always see that after the inevitable correction and wonder how people could have allowed themselves to be drawn into such a trap. More fun, though, is judging when a mistake is taking place: having the courage to say that this or that market response must be wrong.

The current narrowing of spreads in European government bonds - with, for example, a rapid sudden fall in long-term Italian interest rates - is a good example of market error, as the Commentary Column in this section has the courage today to explain.

But most fun of all is spotting the market error that is about to happen: the sudden swing of fashion that pushes a currency, or a set of securities, to an extreme level, and which is subsequently unwound. Here is one current candidate, a market error that has not yet happened but which may well happen in the next few months.

It concerns sterling. It is now clear that the weakness of the pound over the last year was an error, but what about its current strength? And what about the coming sterling boom?

You hadn't heard about the coming sterling boom, but it is an interesting potential phenomenon for the next 18 months. There has been a change in tone in the perception of the pound in the last few weeks. Whereas it was generally to be assumed to be a chronically weak currency - a long- term sell, even if in the short term profits could be made by holding it - now it was beginning to be seen as an ordinary currency, not particularly strong, but not inherently weak. Kleinwort Benson Securities noted in a recent circular that it detected a change in the perception of its overseas customers: sterling was no longer seen as a weak currency.

The same paper also noted the implications of the stronger pound on UK monetary policy. It is an interesting thesis and deserves a wider audience. The central point is that the Bank of England may be underestimating this effect in its concern about inflation. The chart puts together the exchange rate and the interest rate impact on monetary policy. The exchange rate effect is converted on the Treasury's four-to-one rule of thumb, where a 4 per cent rise (or fall) in the exchange rate is deemed equal to a 1 per cent rise or fall in base rates.

You can see that whereas during the spring a lower exchange rate was reinforcing the lax interest rate stance, by mid-summer this was much less marked, and about a month before the rise in base rates the exchange rate began seriously to tighten the monetary stance. The effect of that last quarter-point on base rates is dwarfed by the rise in sterling which is equivalent to a one-and-a-half point rise in interest rates.

The Kleinwort Benson team goes on to argue that there are several reasons to believe that the pound's strength will continue. These include the fact that it is undervalued against the mark; it may benefit further if the recovery of the oil price continues; and it may be boosted by EMU- related speculation (of which more in a moment).

At any rate, the KB team suggest rates of DM 2.55 and $1.70 next year, and suggests that this will take place without the need for as sharp a rise in base rates as markets expect: 6.5 per cent by end-1997 rather than an indicated market expectation of 7.25 per cent.

All very interesting, and I for one, find it very convincing. But let's go one stage further and look at the dynamics of this stronger sterling. Next year a stronger pound will come at a time when the economy is growing fast, faster than any of the other European countries. It will come at a time of considerable political unrest, partly brought about by efforts to meet the Maastricht convergence criteria. There may at some stage in the next 18 months be an unravelling of the whole Maastricht process, if for example, the elimination of the mark is rejected by the German parliament, or if unemployment across the Continent continues to climb.

It is not politically correct at the present time to suggest that the plan will fall to pieces, but it would be absurd to reject the possibility.

At the moment, the main argument that gilts may very well rise is on grounds of convergence: we might make up the leeway against the "hard" European currencies if there is even an outside possibility of participation in the Euro at stage one.

But there is another, entirely opposite possibility: that yields will converge because it becomes clear that either EMU will not happen, or if it does, the euro will be a chronically weak currency.

Britain, for its part, will have a new government, with a new popular mandate. It is difficult to see any set of circumstances where the new government will be weaker than the present one, and if it is a majority Labour government, there will be great pressure to be seen to be "correct" on the currency front. (Memories of the devaluation of 1967 and the IMF rescue of 1976 linger in the markets' sub-conscious.)

On balance, a Labour government will be more concerned to avoid a fall in the value of sterling than a Tory one.

Put all this together and there is a the makings of a market error: pushing the pound up too far.

If you said that to people nine months ago it would have seemed ridiculous. Now it simple seems a bit wacky, probably wrong, but given the startling (and largely unpredicted) recovery in the pound, at least conceivable. But wacky ideas have a way of become accepted wisdom.

I think there is a serious danger that sterling will become too strong in a couple of years' time, not too weak. If that happens, remember where you read it first.