A Tale of Two Currencies: the Dollar and Sterling

June 20, 2017

The political landscapes in the United States and Great Britain underwent transforming change during the past year. In the pendulum that ranges from globalism to nationalism, each of these countries took a decisive turn away from an international orientation. Tighter control over immigration featured prominently in the U.K. decision to leave the European Union and in the victorious message of President Trump. Neither political shift had been expected in advance, so the element of surprise played an important role in the market’s reaction.

However, whereas sterling has weakened sharply since the Brexit referendum a year ago, the dollar is trading resiliently and near to its level when Trump was elected some 7-1/2 months ago. The pound has weakened 12% on a trade-weighted basis over the past year, while the dollar is a mere 0.3% softer since November 8th. The dollar is also 19% stronger versus sterling than its value on the day of the Brexit referendum.

There are several reasons why the two currencies did not react similarly. Let’s start with some economic fundamentals. U.S. inflation has been stable and below the 2% target. British inflation has accelerated and now exceeds 2% by nearly a percentage point. U.S. economic growth is expected to be stronger in 2018 than this year, while British growth is widely predicted to slow. The British current account deficit widened from 1.8% of nominal GDP in 2011 to 4.4% of GDP last year. The U.S. current account deficit, by comparison, fell to 2.4% of GDP from 2.9% of GDP over the same span. In the post-Great Recession period (2009-2016), the U.S. current account deficit-to-GDP ratio averaged 2.5%, 1.1 percentage point less than Britain’s.

The U.S. current account shortfall’s failure to drift sharply higher during the current prolonged expansionary business cycle sets such apart from earlier business cycles when the pattern more closely resembled Britain’s current experience. First-quarter U.S. balance of payments data released today revealed

  • A manageable $116.8 billion current account deficit was posted, equal to 2.5% current account-to-GDP deficit ratio last quarter. In 2006, the year before the financial market crisis surfaced, the current account deficit had crested to 6.2% of GDP. U.S. competitiveness is holding up.
  • The current account deficit was well financed by high-quality portfolio investment flows. Foreign net purchases of U.S. securities climbed to $231.5 billion last quarter from $62.5 billion in the final quarter of 2016, constituting a $169 billion increase between the quarters.
  • Net U.S. purchases of foreign securities totaled $120.3 billion last quarter, $111.2 billion less than the aforementioned $231.5 billion worth of net foreign buying of U.S. securities.
  • Foreign direct investment in the United States was slightly smaller than U.S. foreign direct investment abroad last quarter but only by about the same amount as in the previous quarter. Moreover, the net balance of direct and portfolio investment in 1Q17 favored the United States and thus the dollar by $39.4 billion more than such had in 4Q16.

The factors supporting the dollar but not sterling do not end with better economic fundamentals. For starters, the U.S. political change may prove temporary, perhaps not at the 2020 election but eventually. Every four years, U.S. voters get a chance to express buyers remorse. Brexit, by contrast, is irreversible, and it’s tragic that a decision of such finality was not subjected to a more stringent mandate than a simple majority.

For another thing, the U.K. is more dependent on trade than the United States and therefore more vulnerable as political thinking turned inward in each of those economies. And it’s not just trade dependency. Brexit affects Britain’s largest export market. The U.S. will be able to pick and choose its trade fights and balance the risks of potential benefits and costs against other geopolitical matters that may influence ultimate decisions.

The United States dollar is the world’s king of the hill currently in reserve asset portfolios. Sterling formerly held that role but not in the past 75 years. In common with one another, there are very abundant offshore holdings of both dollars and sterling. Being the current and still largely unchallenged reserve currency hegemon is a huge source of appeal for the dollar. Being a former most favored reserve currency but no longer so is all disadvantage with scant advantage for the pound.

It doesn’t help either that the Federal Reserve is now embarked on a gradual normalization of its ultra-stimulative monetary stance. There were two interest rate hikes by the Fed prior to 2017, another two so far this year, and one or two more by yearend plus several during 2018 barring trouble. The Fed is now moving close to a separate process of balance sheet reduction that seems likely to cut its size eventually from $4.5 trillion to around $3 trillion. U.S. 10-year Treasury yields are 116 basis points higher than British gilts, and 3-month U.S. deposit rates exceed their British counterparts by 97 basis points. These spreads should widen even further.

In normalizing U.S. monetary policy, FOMC officials seem quite united. Not so at the Bank of England, where Governor Carney is holding onto a shrinking majority opposed to undertaking even a first rate hike. Even more importantly, Carney has assumed the mantle of chief Brexit Casandra, repeatedly telling the truth that Brexit will reduce long-term British growth. When a central bank head is predicting trouble for its economy, currencies tend not to be well-bid.

Copyright 2017, Larry Greenberg. All rights reserved. No secondary distribution without express permission.




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