The bad news for the pound isn’t all in the price

The writer is founder and managing director of Longview Economics

Like many major currencies, the pound has fallen sharply over the past 12 months. It fell from 1.40 against the dollar in mid-2021 to 1.15, slightly above its March 2020 pandemic low.

Other than briefly in the mid-1980s, it has never been weaker. Indeed, after a year of trending down, various sentiment and technical patterns suggest, unsurprisingly, that the pound’s decline is now limited.

For contrarian traders, this is therefore a signal that now is the time to start building long positions in the pound. The argument is that the sentiment is so broadly bearish that all the bad news is in the price and the currency is notably oversold.

While this is generally a rewarding way to approach the markets, from time to time these types of contrarian bets fail. In particular, they usually fail when the macroeconomic theme driving the markets is exceptionally strong, compelling and overwhelming. This is probably one of those times.

The US economy appears destined for recession in 2023. The current debate among many markets is whether the recession will be mild or severe. In the moderate camp are those who cite the West’s limited economic imbalances. The worries of those worried about a severe recession are future high levels of interest rates and their impact on a corporate sector with large shares of zombie firms kept alive solely by the low cost of debt. .

You see a snapshot of an interactive chart. This is probably because you are offline or JavaScript is disabled in your browser.

Either way, recessions lead to a sharp tightening of liquidity, which is about to be accentuated by the US Federal Reserve’s quantitative tightening program, the halting of its massive asset-buying spree for supporting the economy and the markets. Starting this month, the Fed’s planned reduction in its balance sheet doubles to $95 billion per month from initial levels in June. This, combined with rising interest rates, is draining liquidity from global markets.

In good times, when liquidity is abundant, economies can experience significant economic imbalances. Structural factors on the balance sheet (whether household, corporate or government) are rarely of interest to market participants when times are good. In slowdowns, however, they are (almost) all that matters.

Unfortunately for the British economy (and its incoming Prime Minister), Britain is the worst offender, among the major Western economies, in terms of imbalances.

A good catch-all measure of imbalances is the current account balance – effectively an aggregator of fiscal sector, household and corporate imbalances. The UK is currently running (according to the latest data) a deficit equivalent to 8% of gross domestic product. While some question marks exist over the accuracy of the first quarter data, the trend over the past two years is clear. The country lives, as former Bank of England Governor Mark Carney said, on the “friendliness of strangers”. At the start of the financial crisis, this imbalance caused problems for the British economy when it reached 3.5% of GDP. On the eve of the recession of the early 1990s, it reached around 4.5% of GDP.

Adding to the woes, productivity growth (a measure of true wealth creation) has virtually stagnated since 2010, implying that the UK economy is not creating much sustainable new income with which to pay its bills.

This poor productivity trend reflects the rise of zombie firms and the over-financialisation of the UK economy, as well as the lack of capital investment. In fact, however, this means that much of the economic growth of the past 12 years has been somewhat illusory. In other words, either built on more debt, less savings and/or a wealth effect resulting from rising asset prices.

Line chart of non-trading traders' net position showing investors betting on further declines for the pound sterling

Further adding to its challenges, the country also has a central bank that seems reluctant to accept the need for higher rates in the UK (and therefore defend the level of the currency). And if Liz Truss implements the tax cuts promised as Prime Minister, the imbalances will surely increase.

As such, and given the looming US and hence global recession in 2023, the dollar’s rapid rise against the pound is likely to continue, with the pound heading towards parity with the dollar (and possibly at beyond) over the next six to 12 months. If so, then a hedge (in a world with no obvious means of hedging) is buying insurance against the risk of loss on UK government debt, i.e. credit default swaps five- and ten-year credit.

At a time of today’s large imbalances and liquidity shortages, it becomes essential to “live within one’s means”. Market concerns about the UK will increase as its imbalances increase. The friendliness of strangers can only be extended so far.

About Vicki Davis

Check Also

Towards COP27: Arab Regional Forum on Climate Finance 15 September

Beirut, September 15, 2022 – The Arab region is highly vulnerable to climate change. The …