Sterling Getting Stoned Again

October 13, 2009

Before the modern dollar-centric era, sterling ruled the high seas of the international monetary system.  The legacy of that era is a very large amount of offshore sterling holdings that make Britain’s currency an easy target for speculators.  The pound is no stranger to currency market misfortune, and the lesson of that history is that whenever British economic fundamentals are unfavorable, the pound is harder to defend and a more exposed candidate to get badly walloped than is a currency with fewer opportunities for speculative selling.  Let’s first review some of sterling’s checkered past:

  • It was devalued by 14.3% from $2.80 to $2.40 in November 1967.
  • After the pound joined the European “Snake” in on May 1, 1972, massive selling pressure forced it to leave that first attempt at a confined joint regional currency float against the dollar just 53 days later  on June 23rd.
  • Sterling was valued at $2.5175 in early March 1973 when the world abandoned fixed dollar parities. The pound weakened below $2.00 the first time ever in March 1976 and slumped to $1.5550 by October 1976, when Britain, holding its hat in hand, received an IMF aid package in return for a sharp tightening of monetary and fiscal policies.
  • Sterling recovered to a high of  $2.4565 on October 24, 1980 but went into a multi-year downturn thereafter.  The pound’s all-time low of $1.0345 was touched February 1985.  The fear of a sub-$1 pound prompted a dramatic tightening of monetary policy, and to this day $1.00 has never been breached.
  • Sterling joined the European Exchange Rate Mechanism in 1990.  As a descendant of the “snake,” the ERM was formed in 1979 as a floating dollar era attempt to contain movement of European currencies against one another.  On September 16, 1992, the pound again abandoned a European joint currency mechanism as massive speculative selling pressure could not be contained by intervention and sharply higher British interest rates.
  • Sterling’s weakest level against the mark in the pre-euro era occurred at DEM 2.1640 in November 1995.

Fast forwarding to the present finds sterling once again performing even more weakly than the beleaguered dollar and below 2.09 against the DEM-translation value of the euro.  But unlike prior British currency crises, neither inflation nor long-term interest rates have been rising.  British CPI inflation was reported today at a lower-than-forecast 12-month rate of 1.1%, down from a peak of 5.2% in the previous statement year to September 2008.  The yield on ten-year Gilts is 3.40%, which compares with 4.67% a year ago.  Ironically enough, the average gilt yield over the past ten years is 4.67% as well. 

Although projected British economic growth in 2010 is similar to projected growth in Euroland, the Bank of England is likely to run a comparatively looser monetary policy.  I expect the Bank of England’s asset purchase plan to be raised in November.  At the ECB and Fed, by contrast, policymakers are already considering what sequence to follow when reversing policy.  The first British rate increase will probably occur later than in the United States or Euroland.  The need to tighten fiscal policy sharply is one reason why the Bank of England has no leeway to reverse gears.  The Conservative Party is likely to unseat the Labor Government in elections next year and plans the sharpest combination of spending cuts and higher taxes in over 30 years.  Even with such a reversal, fiscal projections for the next 5-10 years are scaring investors.  Did somebody say credit rating downgrade?

It’s disappointing too that British growth prospects aren’t better following the massive stimulus from lower interest rates, falling inflation, quantitative credit easing, sterling depreciation, and fiscal pump-priming.  Take the loosening of monetary conditions for one example.  Empirical work by the staff of the Bank of England some time ago estimated that a 1% trade-weighted depreciation of sterling stimulates the economy to approximately the same degree as a 100 basis point decline in interest rates. Since July 24, 2008, the central bank base rate has been reduced by 525 basis points to 0.5%, and the trade-weighted pound fell 27.5% from 105.9 to 76.8.  Such a drop is like a rate cut of 6-7/8th percentage points.  I estimate that total monetary conditions are over 1200 basis points looser now than fifteen months ago.  Last quarter was likely the sixth consecutive one without positive economic growth, and real GDP in the first half of this year was roughly 5.5% less than in 1H08.  U.K. unemployment is still cresting.  Growth next year may be less than 1.5%, and the sum of the fiscal and current account deficits may hover near 16% of GDP.

The final elements in this recipe for a weak sterling stew are 1) the seeming indifference of policymakers to a slip-sliding currency with neither verbal or actual intervention support being used thus far and 2) a rising investor appetite for funding high-yielding asset positions with low-yielding sterling funds.  Sterling has dropped below $1.60, while the euro, which has never exceeded one pound in value, has climbed above Gbp 0.90 and encouraged some analysts to predict that a break of par in the not-too-distant future.  On paper, sterling’s goose looks cooked, but there are no guarantees in currency predictions especially those concerning the pound.  Reminiscent of the reversal of GBP/USD just above $1.00 in February 1985, the symbolism of par with the euro might just galvanize a trend reversal.

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.



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