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The pound seemed to like George Osborne's emergency Budget. On Tuesday morning it was standing at $1.47. By mid-afternoon yesterday, it was above $1.49.
The surprise news that one of the nine members of the Bank of England's interest rate-setting committee had voted for a quarter-point rate rise last month helped, of course.
But the fact is, the pound has been rallying since mid-May. That's when news started to leak about the government's austerity plans.
So is the bear market in the pound now over? Or is this yet another case of buy the rumour and sell the news? Let's have a look…
The pound seems to like the Tories
The pound did not like Gordon Brown as Prime Minister. When he came to power, a pound would buy you around $2. By 10 May, when he finally agreed to step down, it was below $1.50. British purchasing power had fallen by 25% during his time at the top.
The pound does, however, seem to like the Tories.
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In the summer of 2009, the Tories were leading in the polls. Their share of the vote ranged between 40% and 45%. Despite all our debt problems, the pound was quite firm above $1.60.
However, come November, the Tories' popularity began to wobble – and the pound with it. In January-February of this year, their share of the vote slid below 40%. It became apparent that a hung parliament was not only a possibility, but a probability. The forex markets did not like that at all. The pound's slide began to accelerate.
On 6-7 May, stock markets were falling fast and we had a hung parliament. Remember those uncertain days? Unsurprisingly, the pound continued its slide. On 11 May, Cameron walked into Downing Street, but the jury was still out on the coalition government. How would they get on? Down came the pound.
However, Cameron quickly reached a deal with Liberal Democrats and, in doing so, got their strongest talent onside. They thrashed out a compromise in their policies, which may not have entirely satisfied the Tory right and the LibDem left, but nonetheless this new government seemed to be working.
Fiscal sanity is returning to government
And the forex markets responded. On 18 May, the pound made its low of $1.42 against the dollar. That key level of $1.38-$1.40 – a multi-year low – had held. Then, as global stock markets recovered, the pound gradually began to creep back up.
As news of this new budget started to leak out, it appeared that fiscal sanity was returning to government. Nick Clegg suddenly became austerity's greatest champion, regularly speaking up about the need for it. The Tories' declared need for belt-tightening was not being compromised by the LibDems. The pound's rally accelerated.
Of course, there is a lot more to the direction of a currency than a government, but the correlation between the Tories and the pound is most interesting. Here's that story in chart form. The popularity of the Tories in 2009-10, according to election polls, over a chart of the pound vs the dollar.
But now we've had the budget. We were promised austerity and we got it (you can read more on the details here). So what next? Is this a genuine rally in the pound, or just a technical bounce from oversold levels?
Now's not the time to short the pound
For now, the pound continues to rise, which bodes well. From a technical point of view, there is a lot of resistance around $1.50, near the blue trendline I have drawn on the above chart. If it can get through there, it could move to the $1.60 area fairly quickly.
Unless the dollar runs into real problems – which is not beyond the bounds of possibility given the fiscal insanity that still reigns on the other side of the Atlantic – I think it will be quite a while before we go back to $2. But I certainly wouldn't be short the pound here.
The real test for the pound, the Treasury and the Bank of England, however, will come as and when the next crisis hits. Of course, there may be no next crisis. But I remain of the mind that the global banking sector is still largely insolvent; that the euro's problems are still in act one of a three-act tragedy; and that sovereign debt default and another stock market rout are both still in the pipeline.
If pain hits, and the world sees another deflationary scare, will policy-makers resort to another bout of money printing? As my colleague John Stepek noted in yesterday's Money Morning – so far so good, "but the real test for the government and for the UK economy is still to come."
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Dominic Frisby
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