The history of the British pound is as distinctive as that of the British Empire. And just like the sun never set on the Empire, so it goes with the pound, always there through wars, plague, ice ages, and even European monetary integration. Also known as the Sterling, the British pound is one of the oldest reserve currencies and thus considered as one of the most reliable to store wealth. The British pound has its origins in continental Europe under the Roman era. Today, the pound falls fourth in the line of the world’s most often traded currencies – behind US dollar, Euro and Japanese yen. It is also the third most held currency in reserve around the globe.
Unlike other assets which have an inherent beta return (defined as the passive growth of that asset overtime), the value of currencies is only relative to other currencies. Thus, trading currencies can be a source of uncorrelated alpha. Refer to our article: How Can the Average Investor Make Money Trading Currencies?
The recent downward spiral of the British pound tells us, in a world of large economic zones and global interdependence, it is hard to make it alone, and it is sometimes harder to get along with others in a group. The unprecedented pace and extent of the technological and lifestyle changes experienced since the end of the second world war created pockets of immense wealth on a level never experienced in human history. But, at the same time, the opportunity for a large part of the world’s population for upward mobility, the primary promise of healthy capitalism, has weakened significantly. Faced with those changes, cultures and societies have been presented with binary choices between embracing this new normal in globalization or, rejecting it. Events like Brexit and the ongoing Syrian migration expose sharply this choice in a manner that does not accommodate any middle ground, hence rendering the “usual” tools of markets, polling, and political solutions obsolete.
The Brexit movement, fed on a steady diet of nationalistic and anti-globalization sentiment at home, sees itself a sharp rebuttal to the vision of a global, interconnected, highly liquid “city banker” lifestyle. We can see the Brexit event, being a testament and a warning sign for the US and other European countries as to the risks of reversing globalization.
History of the British Pound:
The behavior of the British pound against other currencies is a potent indicator of the country’s economy and foreign policy. In 1975-1976 for example, high unemployment and inflation forced Britain to request a loan from the International Monetary Fund. The pound dropped dramatically before the loan and recovered right after the loan. Similarly, in 1992, the UK exited the Exchange Rate Mechanism, forcing a decline of the Pound of more than 20%.
Political drivers of Pound:
Political drivers at times can become more impactful than fundamental long term flows. In the weeks preceding Brexit, the pound experienced significant spike in volatility. Whether the British voted for or against EU membership would impact far more than their immigration policy and that was evident in how the pound traded. When UK voted to leave the EU, the pound fell to levels not seen in two decades, even though the long term economic implications of how exactly Brexit will play out still remain to be seen and determined in conjunction with its former European partners.
At first glance, having a cheap currency can be attractive for a nation. In general terms, a weaker currency will stimulate exports. Meanwhile, the imports become more expensive and the needs transfer from international markets to domestic products, thereby decreasing a nation’s trade deficit, or increasing surplus over time. However, that is not necessarily the case: Thailand experienced huge currency devaluation under intense speculative attack in 1997, which led to a severe contraction in Asia as bankruptcies soared and stock markets plunged. A weak currency can also signal weak economic growth and instability, and is a reflection of those economic drivers as much as an impetus.
Pound devaluation pressures:
On a short-term basis, there was the immediate devaluation driven by market expectations of what would happen. Even though the pound had been in a bear market for more than two years already, the result of Brexit, which came as a shock to the political and financial elites, forced long speculative positions to exit at painful levels, as evidenced by the poor performances of a number of hedge funds over Brexit.
A close vote but an undeniable outcome to leave the EU, led to the stabilization of pound volatility but began to spread downward pressure on the currency. In addition, there is the long-term devaluation of the pound which is still playing out, and we think, has more room to depreciate.
In the long run, the action of the central banks in order to stabilize and immunize the equity sell-off and potential crisis on the peripherals, ensured further depreciation of the pound through lower rates. The loss of the status-quo created a political situation fraught with perils and pregnant with dire consequences for the pound: successive resignations of pivotal political figures, uncertainty on the transition of power, complete lack of transparency on the timing and the rules of Brexit (e.g. open borders or not, passporting for banks, or not, etc.) to name a few. This led to further increases in the risk premium demanded to hold GBP denominated assets, or the pound in itself.
From a fundamental perspective, though the pound has had an interesting history, it is not different than any other currency in respect to the main drivers: its behavior over any period of time is a function of the total buying and selling of the UK’s goods and financial assets. Having a trading view on the GBP implies having a forward view on all these separate pressures. Given today’s conditions, we expect the pound to weaken further. Prior to Brexit, the UK balance of payments was arguably the weakest in the developed world. The UK current account deficit was at 6% of GDP and foreign ownership of UK assets was high. In order to maintain stability, the UK needs to attract approximately 6% of GDP in net capital flows from the rest of the world.
After the Brexit political catalyst, this picture worsened substantially. UK rates compressed and FX volatility spiked making it highly unattractive to buy UK fixed income assets. Moreover, foreign direct investment (FDI) will likely slow as investment tied to EU trade relations falls. Finally, the current account adjustment will be slow because exports will take time to pick up at the same time that households respond to stimulation (QE, rate cut and rally in equities) to maintain or even increase their pace of spending.
The above pressures would lead to a steady decline in the pound but it is also possible that it enters a sharp dive. This could occur if foreigners become uncomfortable holding unhedged UK assets and either sell their assets or short the pound to protect them.
The options that lie ahead:
We have expressed in previous editorial pieces our belief that a sharp reset is detrimental to overall economic balance and prosperity in the long term, and that the right balance of additional viscosity through regulation and tax policies, as well as impetus through fiscal policies on the other hand, will ensure that the large interconnected dynamic system that is our current world economy does not switch into an overdrive with violent political unrest.