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Toby Nangle
The writer is a commentator on finance and economics and former global head of asset allocation at Columbia Threadneedle Investments
It’s hard to overstate how poorly Kwasi Kwarteng’s so-called “fiscal event” has been received by financial markets.
Nothing in gilt markets in the past 35 years — not the UK’s ejection from the Exchange Rate Mechanism, 9/11, the financial crisis, Brexit, Covid or any Bank of England move — compares with the price moves in reaction to the chancellor’s mini-budget.
The brutal sell-off in UK government debt may have come in the context of rising yields across the globe, but it largely reflected financial markets getting increasingly concerned about the direction of UK macroeconomic policy.
The yields on inflation-protected bonds of other G7 countries, which move inversely to prices, rose modestly. The scale of the much sharper move in gilts in the UK reflected substantially higher expectations of both inflation and real yields. Meanwhile, sterling fell abruptly against both the dollar and the euro, dropping to a record low against the US currency on Monday. This was as bad a verdict as any chancellor could fear.
Forecasting where the pound goes from here is difficult, as predicting currency moves is a dangerous game. Two decades managing investment portfolios has made me humble in this regard. Perfect knowledge of future economic and company news releases would make even the least able equity or bond fund manager wildly successful. But constructing a profitable currency trading model with such information would still represent a tough challenge.
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Furthermore, currency rates are ratios rather than securities. While a sinking pound has filled the popular imagination, the big theme in currency markets this year has been the strength of the US dollar against all-comers.
At the end of August, sterling traded at almost exactly the same rate against the euro that it did 12 months previously, and not far away from its rate versus the euro five years before that. On any given day a falling pound can simply mean a rising US dollar, euro or yen.
In the short run, currency markets are a voting machine. Multiple rates in currency provide plenty of scope for obfuscation, especially when there are political points to be scored.
But in the long run they are a weighing instrument. Over the past 15 years sterling’s value against its major trading partners has diminished significantly on the back first of the financial crisis and then the decision to leave the EU.
Currency markets are now toying with the idea that the UK might be what a balance of payments crisis looks like in a developed market with a floating currency.
In textbooks, a weakening currency has the effect of making an economy’s exports cheaper and its imports more expensive, boosting the former and suppressing the latter.
However, there are few signs that this textbook model applies to the UK. Back in the first half of 2007, the current account — a measure of the country’s net income from trade and overseas investment — was in deficit to the tune of around three per cent of gross domestic product.
Since that time the pound has lost a quarter of its value against the euro and almost half of its value against the dollar. This has increased the cost of imports — hurting real incomes and consumption — but exports have proven to be demand elastic rather than price elastic.
As such the current account deficit is now forecast to average eight per cent of GDP in 2022 and 2023, according to Pantheon Macroeconomics, an independent research consultancy.
Bank of England data going back to 1772 shows that this level of deficit has only been exceeded on three occasions, each of them during the second world war. In simple terms, the British people have become poorer without enjoying the benefits of a more competitive currency that the textbooks promise. And they are more reliant than ever on the kindness of strangers.
The balance of payments crisis claim still sounds hyperbolic. After all, a weakening pound improves the country’s international investment position. And there is no obvious large overhang of borrowings in dollars that would raise the debt-to-GDP ratio if the pound falls.
But sterling has been increasingly at risk of losing its “developed market privilege”, which confers safe-haven status on your assets, increasing the state’s ability to run countercyclical monetary and fiscal policy.
Former US Treasury Secretary Larry Summers’ verdict was that “the UK is behaving a bit like an emerging market turning itself into a submerging market”. The chancellor has so far given every sign of disregarding financial markets in his calculus. It might be time for him to reconsider.
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