Barbarians at the Sterling Gate

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Sterling’s collapse overnight has eclipsed somewhat tepid US labour market data.

The net result is that the Sterling NEER has weakened a further 2% since yesterday and is now down about 20% since November 2015.

While trading desks will have a far better grasp of how risk management systems and liquidity contributed to sterling’s drop, recent political decisions and UK data clearly helped set the scene and will leave the currency vulnerable going forward.

Theresa May’s government and EU leaders have in recent weeks successively dismantled the raft of hopeful predictions which had helped Sterling stabilise over the summer.

Moreover, there is growing evidence that a more competitive Sterling has not translated into materially stronger UK industrial output or exports, with the UK’s trade deficit in goods and services widening in recent months

I would reiterate my view, expressed in early July, that the uncertainty associated with the UK’s possible exit from the EU will likely continue to weigh on the UK economy and currency.

This week’s fall in sterling, if anything, has reinforced my view that the Bank of England will maintain a dovish rhetoric but for now refrain from cutting its policy rate to zero or expanding its current QE program.

Moreover I would not expect the BoE to intervene in the FX market to support sterling at this stage.

Sterling grabs limelight from tepid US September labour market data

Somewhat tepid US non-farm payrolls and labour data for September, which markets have seemingly taken in their stride, should have dominated today’s trading action – after all the Federal Reserve’s two main concerns remain squarely centred on sub-target inflation and areas of weakness in the US labour market (see Federal Reserve – the Father Christmas of central banks, 23 September 2016). While I will look in closer detail at today’s US labour data in my next research note, it is sterling which grabbed the headlines today and warrants a closer examination.

To recap, sterling briefly collapsed 6% versus the US dollar from 1.26 to just north of 1.18 (or even lower according to some reports) in early Asian trading before rebounding to above 1.24 – the biggest intraday drop against the dollar since its 11% cent plunge on 24th June in the wake of the UK vote to leave the EU. The finger of blame for this violent move is being pointed at a sequence of events which lead to a perfect storm:

  1. Sterling had been on the back foot all week after British Prime Minister Theresa May made clear at the Conservative Party Conference on 1-2 October that her government would prioritise immigration controls over the UK’s access to the European single market – what has been termed Hard Brexit. At the same time EU leaders, including German Chancellor Merkel, have been hardening their position vis-à-vis any future deal with the UK. The Sterling Nominal Effective Exchange Rate (NEER) had indeed already weakened about 2.2% between 30th September and 6th October, according to my calculations (see Figure 1).
  1. French President Hollande speaking last night at a dinner in Paris honouring the 20th anniversary of EU think-tank Notre Europe said the EU needed to take a firm stance in negotiations with the UK – in order to safeguard the EU’s fundamental principles – and test the UK’s willingness to leave the EU. The story, reported by the Financial Times, rapidly spread across newswires.
  1. Financial market algorithms which track on-line trends and data patterns were reportedly triggered into selling Sterling, with a possible “rogue” trade (later cancelled) amplifying the move.
  1. This in turn triggered automated stop-losses in investors’ risk management systems, further weakening sterling.
  1. Thin market trading conditions between the close of US markets and open of Asian markets on a non-farm payrolls release day likely exacerbated the magnitude of the move.
  1. GBP/USD quickly rebounded back to 1.24 but the release of weak UK industrial output and trade data for August (at 09.30 London time) likely contributed to GBP/USD falling back to 1.23.
  1. GBP/USD was trading just north of 1.24 at 15.00 London time.

The net result is that, at the time of writing, the Sterling NEER has weakened a further 2% since yesterday and is now down about 20% since November 2015 (see Figure 1).

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There will be much debate about which of these six steps played the biggest part (if any) in what is being described as a “flash-crash”. Trading desks will have a far better grasp of how steps 3, 4, 5 may have precipitated this collapse in Sterling. But it is clear in my opinion that steps 1, 2 and 6 helped set the scene for a sharp correction in an already weak Sterling and will leave the currency vulnerable going forward. As I highlighted in Post-referendum circular reference (7 July 2016), the uncertainty associated with the UK’s possible exit from the EU will likely continue to weigh on the UK economy and currency, via subdued confidence and wages, delayed spending, investment and hiring, and strains on government finances.

 

Raft of hopeful predictions successively being dismantled

Sterling had already collapsed 6.5% between November 2015 and June 2016 before it collapsed a further 10% in the wake of the UK referendum on EU membership on 23 June (see Figure 1). Sterling then found a floor over the summer, with a raft of hopeful arguments being put forward. These hopes have systematically been dismantled in the past three months.

First, the possibility was initially put forward that the UK government would hold a second referendum which could overturn the electorate’s wish for the UK to leave the EU. But Theresa May’s government has made clear that this would not happen.

Second, there was a strong belief – which I shared – that because the referendum result was only advisory, not legally binding, the British lower house of parliament (the House of Commons ) would have to vote on triggering Article 50 which officially sets in motion the two-year process for the UK to exit the EU. This would have in turn incentivised the government to put forward a preliminary deal with the EU which was palatable to the members of parliament (as the Prime Minister would have not risked Parliament not triggering Article 50 and sapping her authority).

But Theresa May has said that her government, not Parliament, would trigger Article 50. This decision is the object of a number of legal appeals but it’s not clear to me that the highest court in the land will reverse Theresa May’s decision for fear of setting a precedent.

 

Increasingly clear that UK government will have to reach potentially painful compromise

Third, there was hope – always misguided in my view – that somehow Theresa May would successfully negotiate a deal with the EU which gave the UK access to the European Single Market, greater control over immigration and cheaper access to the benefits which the EU conveys. The view was that the EU had more to lose than the UK from reduced trade and that EU leaders would willingly reform the EU in order to stop other countries going down the same route as the UK.

But as I forecast in Post-referendum circular reference (7 July 2016), EU leaders – including German Chancellor Merkel – have made very clear that unfettered access to the single market would have to go hand in hand with the free movement of labour and contributions to the EU budget. Even US President Obama as early as late-June let slip that the UK could end up at the back of the queue to sign a new trade deal with the US. French President Hollande last night highlighted the EU’s weariness of allowing the UK to cherry-pick generous new concessions for fear of incentivising other EU countries to leave the EU and re-negotiate their trade agreements on different or even better terms (the fear of precedent and contagion).

 

Theresa May playing the immigration card and not clear she will change tact

Fourth, while it has become increasingly apparent that EU leaders are hardening their resolve not to give in to British demands, the hope was that Theresa May would opt for a new EU agreement which put access to the European Single Market at the top of the priority list – Soft Brexit or Brexit-Lite. But instead the British Prime Minister and her cabinet have set out a framework which privileges control of EU immigration into the EU – Hard Brexit. This could mean the UK losing a degree of access to the Single Market or at least paying a higher price to access EU markets, and in turn damage the open British economy. A number of cabinet members, including Home Secretary Amber Rudd, have gone a step further and suggested that UK companies would have to disclose how many non-UK nationals they employ.

Moreover, time is running out for the British government to reconsider its stance as Theresa May said the government would trigger Article 50 by March 2017. This would imply that by spring 2019 the UK would be out of the EU, regardless of what new deal it has been able to negotiate with its EU partners. Of course, the UK government could decide to change tact during this two year window, particularly if Parliament which will likely have to vote to dissolve existing EU treaties signals its opposition to the draft deal it has been handed. But this would be a serious loss of face for the government and therefore those hoping for such an outcome may again be disappointed.

It would appear that Theresa May’s ruling Conservative Party still thinks it can have its cake and eat it or that at the very least it estimates that the economic and political benefits of controlling immigration into the UK outweigh the costs. From a purely political standpoint, I can see how Theresa May’s government reached this conclusion. British voters, or at least those who voted to leave the EU, have vocalised their feelings about what they perceive as the cost of excessive immigration. The Conservative Party will want to capitalise on this, particularly at a time when the main opposition parties are in disarray.

In particular, the Conservative Party may hope to steal support from a weakened United Kingdom Independence Party (UKIP), which has championed anti-immigration policies and came third in the 2015 national elections with nearly four million votes. Moreover, the Conservative Party may be trying to capture traditional supporters of the Labour Party – the UK’s largest opposition party – which have been wavering in recent months following a brutal and destabilising battle for the Labour Party leadership.

 

Weaker sterling struggling to lift UK industrial output and exports

Finally, and perhaps most importantly, there was the consolation that the British economy had rebounded post referendum thanks largely to sterling’s depreciation to more competitive levels. Indeed there has been evidence to suggest that the adjustment via a weaker currency was supporting economic growth, including retail sales and manufacturing, demand for UK assets (including property) and UK equities(see UK Economy post referendum – for richer, but mostly for poorer (26 August 2016). Specifically, there was evidence that sterling’s depreciation was helping drive industrial orders, particularly for companies which export outside of the EU and are not prey to the government’s ongoing trade negotiations with EU partners.

But this has not translated, or at least not yet, into materially stronger UK industrial output or exports. Figure 2 shows that both manufacturing and industrial output have struggled in recent months, suggesting that the fall in oil and gas production (due to some field shutdowns) is only part of the story.

Perhaps more importantly for an open, service economy, Figure 3 shows that while growth in the sterling-value of imports of goods and services has remained strong, growth it the sterling-value of exports, which was robust in Q2, has collapsed in recent months. The result is that despite sterling’s 20% depreciation in the past year, the UK’s trade deficit on goods and services has actually increased to close to a 3-year high (see Figure 4).

This would tend to confirm that my view that the benefits to external trade from even a large one-off currency devaluation are likely to wear off as increases in companies’ imports and cost base (due in part to a lack of import substitution) start to erode gains in export-price competitiveness. This has certainly been the past experience for many countries which have found out that the export-driven model of growth (via competitive devaluations) is questionable at best. That is not to say that a weaker sterling is not helping the British economy weather the post-referendum storm, but one should be weary of over-stating its benefits.

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Bank of England to stand pat for now

The Bank of England (BoE) has said it would look into sterling’s collapse this morning – which one would expect a mature central bank to do. But it’s not obvious that the BoE will do much at this stage beyond trying to reassure markets, the electorate and the world by saying that it is monitoring the situation, remains committed to maintaining liquidity in the banking sector and will take appropriate steps if necessary.

The BoE is likely to continue favouring monetary and credit policies which explicitly help spur lending, spending and investment. But whilst sterling’s depreciation could be qualified as “disorderly” I would not expect the BoE to intervene in the FX market to support Sterling at this stage.

From a monetary policy perspective, this week’s fall in sterling if anything has reinforced my view that the BoE will maintain a dovish rhetoric but for now refrain from cutting its policy rate to the psychologically-sensitive level of zero or expanding its current QE program. For starters, the BoE will want UK markets to stabilise and volatility to ease, which I don’t see as compatible with another rate cut near-term. Moreover, the latest leg-down in sterling has loosened UK monetary policy and therefore markets have to some extent done the BoE’s job. Nevertheless the BoE will want to come across as pro-active and this will likely mean the BoE keeping further monetary policy easing on the table – which was exactly its message at its 15th September policy meeting (see All to Play For, 15 September 2016).

 

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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