Spotlight on Sterling

August 6, 2018

As a former hegemonic reserve currency with enormous residual offshore holdings, sterling is intrinsically susceptible to being shoved around disproportionately whenever favorable or unfavorable fundamental economic shifts arise. From $2.80 prior to the November 1967 devaluation, the pound slid to a low of $1.55 less than a decade later in October 1976 and touched an all-time nadir of $1.0345 in February 1985. During speculative frenzies like the one that forced humbled British officials to abandon the European Monetary System in September 1992, sharp increases in the Bank of England’s policy rate have been no match for the market. On the 16th of that month, after lifting the Bank Rate by 2 percentage points to 12%, British government officials openly considered a further move to 15%, but when even that prospect only fed more speculation, sterling was withdrawn from the EMS and allowed to float sharply lower in the absence of intervention support.

The surprise Brexit referendum vote on June 23, 2016 constituted an enormous potential shift in British fundamentals, but the subsequent passage of time has been fraught with uncertainty, because the terms of Britain’s departure from the European Union still need to be determined. Initially, the pound fell about 20% over the roughly six and a half months following the vote. When British growth surpassed expectations and as a framework for negotiating the terms fell into place, the pound gradually clawed back ground until just this past April, it was within 5% of its pre-Brexit level.

In the past 3-1/2 months, however, Brexit news has been extremely discouraging. The clock is winding down, and just under 7 of the original 24 months for working out a deal remain. Parliament and the British people are very polarized over the decision and how to go forward. Prime Minister May’s cabinet has not functioned well, either, and so the possibility of the once unthinkable result that no deal may be struck has increased steadily. The trade minister gives it a 3 in 5 chance, and Bank of England Governor Carney perceives the risk now to be “uncomfortably high.”

It is an inauspicious sign that last Thursday’s Bank of England rate hike did not boost the currency. Supporting sterling was not the given reason for the tightening. It was the first follow-up increase for an initial rate hike last November and resulted in the highest Bank Rate, albeit just 0.75%, since prior to March 2009. 2Q monthly data suggest that U.K. growth in the spring was better than last winter. British inflation is currently at 2.4% versus a 2.0% medium-term target that is unlikely to be secured sustainably before 2020 and then only if some gradual and limited rate increases are engineered.

There are other reasons why sterling is falling. The dollar has been better bid generally as a result of accelerating U.S. growth and Fed rate normalization. The financial sector plays a bigger role in the U.K. economy than most, and no negotiated Brexit arrangement likely would cause a significant exodus of many financial market activities. While Britain avoided a Brexit recession, growth did slow from marginally more than 2.0% in the year prior to the Brexit vote to 1.75% in 2017, and 1.25% over the last two reported quarters. That’s not a lot of pre-existing momentum from which to absorb a large adverse shock like leaving the EU without any worked out new arrangements. Also, the U.K. current account deficit remains above 3.0% of GDP and thus excessive.

In trade-weighted effective terms, sterling didn’t rally over the 15 months through April as much as it had against the dollar. If Brexit talks continue to evolve poorly, trade-weighted sterling depreciation offers no constraint against an extension of its losses. The pound in the final quarter of 2016 was 10.4% weaker on average than its second-quarter mean that year, and the only quarter from the beginning if 2017 through mid-2018 to show a greater average slide than in 4Q16 from 2Q16 was last year’s third quarter when the drop was 10.5%. By the spring quarter of 2018, the quarterly average was just 7.4% lower than the quarter two years earlier, which was when the referendum had been held. As of last Friday, sterling’s trade weighted index, although showing a 9.1% drop from the 2Q16 mean, remained above its post-Brexit nadir.

If sterling continues to worsen and Brexit concerns become more urgent, a self-reinforcing dynamic of weaker fundamental news and market-imposed monetary tightening looping back to pressure on the pound could ensue. Alternatively, the fundamental risk here is political, not economic, and a different, more favorable outcome to the Brexit process is possible as long as negotiating time remains. Stranger things have happened even this year, like North Korea and the United States threatening one another with nuclear war only to then have their presidents meet in a summit at a neutral site.

Copyright 2018, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

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