Why the pound is at a 31 year low and what happens next

There has been plenty of analysis produced about what the impact of the UK’s decision to leave the EU will be on the country’s economy. 

But despite this swathe of literature, nobody really knows what the ultimate outcome will be.

In the short term, the UK economy has held up better than most people expected. However, the price action in the foreign exchange (FX) market suggests that the UK is going to have to face up to some serious challenges.

The pound (GBP) was sold aggressively as soon as it became clear on the night of June 23 that the country had voted to leave the EU. After initially rallying to 1.5000 dollars, the pound-dollar exchange rate, known as cable in the FX market, plunged to a low around 1.3225. This was one of the largest one-day falls by a so-called major currency in history.

Even though it has made a few half-hearted attempts to bounce, the pound has remained weak ever since. At the time of writing, cable is trading close to 31-year lows around 1.2700 and the pound has also lost around 15% of its value against the euro and even more against the Japanese yen.

Despite the old adage, markets are not always right. Many will argue that the slide in the pound’s value will ultimately be beneficial for the UK’s economy. Competitive devaluations have become a theme in the FX market and in theory sterling’s fall will make the UK’s exports more competitive. Of course, the flipside is that imports will generally be more expensive and inflation will rise, but many see those threats as less of an issue.

Additionally, movements in other UK markets, notably equities, do not suggest that the country’s economy is poised to fall off a cliff. The FTSE 100 has climbed more than 20% from the lows posted immediately after the EU referendum.

However, this is not a reflection of confidence that the UK economy will steam ahead untroubled by Brexit. Instead, it is partly a result of the fall in the pound – numerous FTSE 100 heavyweights make most of their earning overseas – and partly because of a desperate search by global investors for yield. This has resulted in a strategy known as Lena – Long Equities, No Alternatives.

Sterling’s weakness is a better indicator of sentiment towards the UK than equity strength. Quite simply, it is far easier to express the view that the UK economy is going to be challenged through FX than through other assets. Shorting (selling) the pound is simple to do; shorting equities is not and, for the moment at last, nobody really wants to sell bonds.

It could easily be argued that pound has now fallen far enough. Recent UK economic data have been relatively robust and sterling is undervalued on a purchasing power parity basis by around 10%. Furthermore, the speculative market is very short and there is a lot of uncertainty elsewhere, such as the US elections and the possibility of yet another EU crisis.

However, even if the pound does not fall further, it is probably going to struggle to recover significantly. The latest sell off was triggered by news that the UK government will trigger Article 50 of the Lisbon Treaty to leave the EU by the end of Q1 2017. This process will not be quick, and it will be convoluted, which will lead to an increase in uncertainty, which markets hate.

Even if the pound manages to recover some of its losses, for the moment any bounces will be met by fresh selling. If it does continue to fall, how low will it go. Nobody really knows, but cable’s all time low occurred in February 1985 when it traded briefly below 1.0400. Its nadir versus the euro was set more recently in December 2008 when EURGBP reached 0.9800 (or 1.02 expressed as GBPEUR). Few analysts are predicting a return to these extreme levels, but stranger things have happened. A cable move towards 1.1500 and EURGBP towards 0.9500 looks entirely feasible.

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