Trying to make sense of a free-fall in the British pound
Sterling’s plunge against the US dollar since its April high of 1.4376 has been epic in both scale and swiftness. Cable trades at 1.3263 as I write. What went so terribly wrong for the currency of Her Majesty’s sceptered isle in the spring of 2018?
One, King Dollar. The US-China trade war and an inter-continental emerging market currency crisis led to a global safe haven bid in the US dollar. The US Dollar Index bottomed at 88 and has now surged to 95.
Two, relative central bank monetary policies. The Federal Reserve has raised its Fed Funds rate twice in 2018 while a first quarter economic slowdown and disappointing UK data forced the Bank of England to abandon its earlier hawkishness on interest rate policy and not raise the base rate in its May MPC conclave. The logic of relative data, central bank rhetoric and US TreasuryBritish gilt yield spreads screamed short sterling once cable fell below 1.40.
Three, Theresa May’s Tory Cabinet faces bitter divisions over Brexit (the customs union, the Irish border) and lacks a stable parliamentary majority in Westminster. This toxic political debate is reminiscent of Mrs Thatcher’s cabinet in 1989 or John Major’s revolving door in Downing Street in mid-1996 — in short, a green light to short sterling as the Tories head for either regiside or election defeat.
Four, divisions within and among European governments have raised the political risk of Brexit negotiations with the UK. A populist-far right coalition in Italy, a new Socialist government in Spain, a political challenge to Chancellor Merkel from her own CDU/CSU coalition is not exactly a formula for a successful endgame
Divisions within and among european governments have raised the political risk of Brexit negotiations with the uK
to Brexit even after March 2019. This is obviously negative for sterling.
Five, even international politics and offshore capital flows militate against sterling strength. Relations between the EU and Washington have deteriorated since Trump’s G7 debacle in Quebec — and Britain has the ultimate special relationship with the US. The corruption crackdown in China, tighter sanctions on Russia, the oil price crash in the Gulf and devaluations in West Africa have sharply reduced offshore capital flows to the London property markets. Prime London has fallen and Battersea/ Nine Elms is a leveraged disaster for investors.
Sterling has historically punched above its weight in the foreign exchange market due to the legacy of the British Empire, North Sea oil, the Thatcher-era privatisations and London’s role as the epicentre of the Euromarkets, derivatives and asset securitisation. Yet the past decade has witnessed the most traumatic trade weighted devaluation of sterling (2.10 in November 2007, 1.3263 now) in the history of modern Britain. This devaluation has been greater in scale than Black Wednesday in 1992, Harold Wilson’s “pound in your pocket” debacle of 1968 and Ramsay MacDonald’s decision to exit the gold standard in 1931. However, this does not mean that sterling is a nobrainer buy, even at these admittedly optically cheap levels.
I believe a sustainable sterling rally needs multiple catalysts — an inflation overshoot or strong data momentum that forces Governor Carney to hike rates in August (dream on) and November, a lesstoxic milieu in Westminster, tangible progress in the Brexit Chinese water torture, a tacit acknowledgement of emerging market contagion by the Powell Fed and a sag in King Dollar. Am I confident in these potentially bullish catalysts for sterling? Absolutely not.
The adage “the trend is your friend until the trend comes to an end” sadly holds true for sterling until the smoke signals from Threadneedle Street resurrect the battered sterling bulls once again. This could well happen if the pound falls below the November 2017 lows of 1.26, when the Old Lady panicked on inflation and began to jawbone cable higher to 1.36. The currency gnomes in London do not expect such a policy U-turn in August.
The Bank of England minutes lifted sterling as three members of the MPC dissented in favour of a base rate rise.
Yet clashes at the EU summit in Brussels could well reverse cable’s two big-figure gain on the “hawkish hold” message from Threadneedle Street. I need to see a successful test of 1.3340 to cover sterling shorts. This will be the proof of the pudding for a trend reversal to 1.3480. If not, I can only repeat the old warning — caveat emptor!