The shock of the disappearing mark

George Soros, the legendary speculator whose activities helped nudge sterling out of the ERM, is back on the bear tack, at least as far as the pound is concerned. Through the autumn sterling climbed steadily and by the beginning of last week had recovered to within 5 per cent of its pre-Black Wednesday level. Against the US dollar it had reached $1.71. Then a wave of selling orders, provoked apparently by sales by the Soros funds, pushed it down again, so that by Friday it was below $1.63.

Nevertheless, the pound does remain sharply up on the level of a year ago, not just against the dollar but more notably against the main continental currencies. We can now go back to France, with an exchange rate of around nine francs, without having to count the pennies. As far as British industry is concerned the modest decline on the pound over the past few days is a relief, for exports were in danger of becoming seriously unprofitable. But if international investors, in general, like sterling, they are much less attracted to our government securities. These have failed to perform at all impressively in the past year, missing out on the surge in price which has occurred in all the other "fringe" European currencies. The interest rate on gilts is pretty much the same as that on Italian government bonds, despite the fact that debt as a proportion of GDP is half the Italian level, and both inflation and the fiscal deficit are lower. You can see this failure of interest rates on gilts to converge with those of German bonds - in contrast to rates on Italian, Spanish and Swedish bonds - in the left-hand graph below. True, we didn't do as badly as they did in 1994/5, but we ought to be back to the sort of relationship that applied in early 1994, and we are not.

So there is a puzzle. Why should British currency be strong but the British government's debt be weak?

There are two simple answers. The first is that markets can make mistakes, and that at the moment they are doing just that. If anything they are over-rating the pound, and while one can justify present levels, any further rise (which may well take place in the next few months) will push it into overshoot territory. On the other hand, the markets are under-rating gilts, failing to see that the UK may well be the only EU country this year (bar Luxembourg) that meets the Maastricht fiscal conditions of a deficit of less than 3 per cent of GDP and total public debt of less than 60 per cent of GDP.

There is a lot in that, but saying the market is wrong is a bit of a cop- out, for it does not explain why the market is wrong. The other simple answer helps a bit here. The case for sterling is high interest rates. They are not high by historical standards, of course, but the UK looks like being the fastest-growing of the Group of Seven economies this year, and accordingly the most likely to need to be restrained by higher interest rates. The market expects base rates to be 7 per cent by the end of the year, and some people would go higher, perhaps to 7.5 per cent. In addition, concern that the new "euro", if it happens, will be a weak currency has depressed the core continental currencies, leading to a flight into both sterling and the dollar.

By contrast, the market has worries about gilts because it is not too sure what will happen after the election to public spending and borrowing. The stern words from Gordon Brown about sticking to the Tory spending plans for the first two years in office may have helped a little, but there is an underlying concern about the present government's plans, so that may not be enough. On paper the borrowing figures for this coming year look fine, but that is just on paper.

Ask market traders and this is the sort of answer they give, so I suppose there must be something in it. Maybe people pile into sterling on a very short-term view of the currency, while they shun gilts because they are worried about the medium-term outlook. But this is not a very satisfying answer either, because there is a fundamental logical difficulty in the idea that sterling should be a safe haven against suspect European currencies but gilts should not be a safe haven against presumably equally suspect European government bonds. If the euro were to turn out to be a weak currency, expect all bonds denominated in that currency to plunge.

So if the two straightforward explanations have problems, is there a better one around? I think there is and it runs like this.

I think the markets are in something of a state of shock - not a shock in the sense that the oil price has soared, or share prices are plunging or the ERM is breaking up, but in something deeper. The shock is caused by two things: the possibility, even probability, that the German mark will disappear; and the financial disruption in Japan.

For the past 30 years there have been two fundamental principles deep in the psyche of long-term investors. One was that you should always be long of the mark and the yen. Whatever happened to short-term swings in currencies, the interest rate that you might earn on them, the fluctuations in bond markets and so on, the mark and the yen in the long run would always appreciate in value. Now the mark may disappear, and whatever view one takes of the industrial strength still underpinning the yen, the weakness of the Japanese financial system makes all Japanese assets a riskier notion.

So maybe, just maybe, an era has come to an end - let's call it the post- war adjustment - and a new one has begun. We don't know what that new era should be called, but we know it will be, in investment terms, different.

What we are therefore seeing is the market groping around for some new anchors. Uncertainty about the core European currencies has driven funds into the main alternative, the dollar, because in 10 or 20 years' time, irrespective of what happens in Europe, at least there will be a dollar. Maybe the long post-war decline of the dollar against the mark and the yen is over. Sterling has benefited from a similar instinctive move, with the suspicion that maybe that long decline is over, too.

Really? Glance at the graph on the right. It seems to show a long-term downward trend - a jagged one, but down none the less. But now put your hand over the left side of it. There is no decline; in fact the pound against the dollar has been pretty steady over the past 10 years. So maybe it is not so unreasonable that dollar strength should have spilled over into sterling. Sure, that is against the dollar, not against the mark, but if there is not going to be a mark in five years' time and you don't want to be entirely in dollars, where else do you go?

Now consider gilts. Here the markets are also groping around for some new rules. The old rules were that the Germans and the Japanese were fiscally sound and the British and Americans were a bit suspect. (Well, more than a bit in the case of the UK.)

Not enough has happened to change that view. Maybe the US will move to fiscal balance in the year 2002, as the president expects. But maybe not. Maybe a new British government will not slither back into trying to borrow when the electorate tells it that it must not tax. But the markets don't really trust either main party, and so they impose a risk premium. They don't much trust Sweden, Italy or Spain either, but they do expect fiscal policy in these countries to be corralled by the EU. They know the UK won't let that happen.

The result of all this groping for new rules seems to be a willingness by the markets to trust sterling, but not a willingness to trust Her Majesty's Government. That sort of makes sense. Well, it sort of makes sense to me, even if it doesn't to George Soros.