Sterling takes a pounding

For well over a decade, the British pound has been viewed as one of the strongest and most stable currencies around. But events this summer seem to be changing this picture. In recent weeks, the pound has depreciated to its lowest level since 1996 and sterling has fallen by more than 12 cents (or more than 5 per cent) against the US dollar since the start of August.

4 main forces seem to be at work

Falling commodity prices:

One reason is simply a rebound in the value of the dollar and linked to this is the falling price of crude oil. Many investors took advantage of a cheap dollar to buy commodities, gold and other precious metals – all of which are priced in dollars. But as energy, food and metal prices start to dip lower - so speculators are unwinding these positions by selling. The dollar is gaining ground – and one currency’s strength is often another’s weakness.

Darkening economic clouds:

We have seen a series of pessimistic forecasts for the short-term performance of the British economy. Expectations for GDP growth have been slashed and the Bank of England joined in with their latest inflation report hinting that a recession was now a real possibility at some point between now and the end of 2009.

Prospect of lower rates:

A recession in the UK next year will curb inflation risks and give the Monetary Policy Committee scope to lower official base interest rates. If the return on UK bank and building society deposits falls relative to other countries, this reduces the demand for sterling in the foreign exchange markets.

An overdue adjustment:

Traders in foreign exchange markets have felt for some time that sterling is over-valued – some evidence for this is provided by our huge current account deficit in trade with other countries. So a depreciation of the pound is perhaps overdue and may help to rebalance the economy away from consumption towards exports