When it comes to investing, there are numerous questions that need to be asked, and lots of things which need to be properly understood before committing your hard-earned money
UK pound sterling: How low can you go?
23 June, 2016. It’s a day in our history which few Britons will forget. Voters headed to the polling stations, and from 10pm BST, the votes began to be counted. Nigel Farage declared that “it looks like Remain will edge it.” The markets had endured a tumultuous day, but Farage’s sentiments reflected both in terms of investor confidence and bookmakers’ odds, which were suddenly stacked heavily on a Remain victory.
In keeping with this theme was the performance of the UK pound sterling, which, after a rollercoaster year, almost touched $1.50 on the day. It was also at a comfortable €1.31, and all seemed well. But then the rug was pulled from under it.
Since the referendum vote, the currency has sunk to a series of new 31-year lows, and has lost around 18 per cent of its value against the ‘greenback’. It even plunged as low as $1.18 amid a ‘flash crash’ during the recent Conservative Party conference, as the Prime Minister indicated that the UK may leave the single market – or a ‘Hard Brexit’, as it’s been termed. The pound has since stabilised somewhat, but anxiety remains about its future performance.
Will the pound fall further?
Many economists believe that this stabilisation will only serve as brief respite, given that the process of withdrawing from the European Union has yet to actually begin. Certainly currency is one of the more sensitive and volatile economic indicators when it comes to turmoil and uncertainty, and it is this prospect of a Hard Brexit which seems to be the sterling’s greatest Achilles heel.
"The argument which is still presented to us, that the UK and EU will resolve their differences and come to an amicable deal, appears a little surreal,” commented David Bloom, chief strategist at HSBC in a BBC interview recently. "It is becoming clear that many European countries will come to the negotiation table looking for political damage limitation rather than economic damage limitation. A lose-lose situation is the inevitable outcome."
Bloom also believes parity with the euro is likely by the end of 2017, an assessment echoed by John Wraith, who is head of UK rates strategy at RBS. And with respect to the other side of the pond, Bank of New York Mellon expect to see the pound slump to around $1.10 within the next 12 months.
The effects on interest rates, inflation and balance of payments
Much of the experts’ gloomy short-term predictions have centred on the direct impact of the Brexit negotiations in the coming months and years. However, there is another important factor at play – monetary policy. Fundamental economic principles dictate that national interest rates – or Bank of England rates, in the case of the UK – have a directly proportional relationship with currency value; other things equal.
In August, the Bank of England made the historic decision to cut base rates to new record lows of 0.25 per cent as a continuation of its quantitative easing programme in a bid to give the economy a boost. However, one consequence of this is further downward pressure on the value of the pound, and with Governor Mark Carney implying that rates could be cut to 0.1 per cent in the near future, it is difficult to know where the floor is in terms of future value.
For a country as heavily dependent on imports as the UK, this will almost certainly lead to inflationary pressures, with the recent ‘Marmite-gate’ between Unilever and Tesco arguably a sign of things to come.
Yet there are of course certain advantages to a weak pound. Exporters benefit hugely, as they are able to trade at more competitive prices. In addition, there is another law in economics which may be of interest. The Marshall-Lerner condition states that ‘for a currency devaluation to lead to an improvement (e.g reduction in deficit) in the current account, the sum of price elasticity of exports and imports (in absolute value) must be greater than 1.’
In the UK, past experience suggests that demand tends to be inelastic in the short run, but elastic in the long run, thus meaning Britain could naturally redress its currently lopsided balance of payments as time goes on.
What can we expect in the years ahead?
Back in early 1985, the pound sank to a low of $1.05. This was against a backdrop of miners’ strikes and race riots in London, coupled with the fact that the dollar itself was particularly strong at that time. President Reagan, in collaboration with the Federal Reserve, had opted for an expansionary fiscal policy to revive the economy. This led to higher long-term interest rates, which, in turn, attracted large inflows of capital.
The independence of the Bank of England has been a hot topic of late, but there is no reason the UK couldn’t go down a similar road, with increased fiscal spending being counter-acted by a more contractionary monetary policy – or at least an end to quantitative easing. And of course, should the Brexit negotiations go a different way to what is expected, and the UK either remain a member of the single market, or retain meaningful access to it, then this could spark a powerful resurgence.
But the reality is that, in the event of a Hard Brexit, inward investment from Europe would likely dip, meaning Britain would need to look to pastures new to fill this void. And for this to happen, it would need the pound to fall further in order to encourage this.
Perhaps at a macroeconomic level, an even greater decline in the pound may well turn out to be a good thing, and many would argue that it is a sensible means for Britain to recalibrate its economy. Yet at a household level, with wage growth remaining stubbornly stagnant, it seems that a continuation of this trend in the pound’s devaluation would lead to a squeeze – at least in the short run anyway.
So, what lies in store for the pound in the years ahead? That, it’s fair to say, is anyone’s guess.
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