History shows sterling not heading off a cliff

LONDON (Reuters) - Sterling's breath-taking slide to two-year lows against the dollar is one of the most significant in the past 20 years and may look like a crisis, but history indicates that it won't fall much beyond fair value levels around $1.60.

The pound's decline from a psychologically-key $2 started a month ago GBP= and gathered intensity last week to culminate in a 6 percent drop so far this month to as low as $1.8510.

Monthly falls of 6 percent or more have only occurred seven times in the last 20 years, Reuters charts show, but in almost all those cases it has always bounced back from the fair value level of around $1.60.

The latest drop has set it on course for the biggest monthly decline since January 1997 -- the year the political landscape shifted from 18 years of Conservative rule to the-then New Labour government.

"It's come back from a level that was grossly overvalued to one that is becoming sensible. There is further to go," said Trevor Williams, head of group economic research at Lloyds TSB Financial markets.

Looking at the other major falls, however, the latest correction pales against the 12.7 percent drop in sterling in October 1992 that accompanied Britain's exit from the euro's Exchange Rate Mechanism (ERM.L) precursor.

The pound's darkest hour was defined by declines of more than 10 percent in both September and October 1992, culminating in a 25 percent devaluation to $1.51 at the end of the year that earned mega-investor George Soros around one billion pounds.

Few analysts expect anything near this type of calamity this time round, even as it approaches fair value levels.

"To simply come from the $2 level, which had become so familiar, to here in the space of four weeks to me seems significant," said Simon Derrick, head of FX research at Bank of New York Mellon.

"But is 'collapse' the right word? 'Collapse' perhaps has too many memories of ERM crises in the past," he added.

NO PANIC

The ferocity of the fall, however severe, has not sparked panic among traders, most of whom are reluctant to coin it a complete capitulation, arguing that it will inevitably fall towards fair value levels, but not until well into next year.

"My feeling is that we are going through $1.80 pretty quickly, and eventually to $1.70 by the first half of next year," Derrick said.

An 8.6 percent fall in March 1991 came as the dollar got a hefty boost from the U.S. victory in the first Gulf War and as a multi-year crisis in the UK housing market started to unfold.

Three of the months in which the pound lost 6 percent or more in the last two decades were in the high inflationary years of 1988 and 1989.

CONTEXT

The current problems for the UK economy and the pound have mounted slowly in the wake of a year-long global credit crunch with spiralling inflation and slowing activity, calling into question the BoE's ability to react nimbly.

Looming recession, pointed to in the Bank of England's Inflation Report last week, seems to have tilted the dial in favour of interest rate cuts from the current 5 percent, which would erode the G7's highest-yielding currency's yield appeal.

Yet the current move is being received calmly, with some voices sounding almost relieved, as an inevitable capitulation to mounting international and domestic economic stress versus a seemingly reinvigorated dollar and a domestic clamour for growth-boosting interest rate cuts.

One factor keeping current and future moves in order is sterling's fairly resilient recent performance against the euro -- backed by the dollar's major comeback from record lows.

"It's all in the context, clearly we've seen a sharp fall in cable (sterling/dollar) but the rate of sterling against the euro really hasn't changed all that much in the last couple of months," Investec economist David Page said.

The euro has hovered in a roughly two-pence range between 78 and 80 pence EURGBP= over the past four months.

Whatever the real source of the pound's quick-fire tumble, analysts say it is a necessary component to help the floundering British economy to re-balance.

"A period where we need to grow and rebalance away from domestic demand towards investment and industrial output growth implies a weaker currency and that's what we're seeing," Lloyds TSB's Williams said.

"There will be slower growth but it means we'll get much more sustainable growth."