Regular readers will know my stance on Brexit. And I voted as I did – after much reflection – well aware of the risk of turbulence ahead. Just as I anticipated that the Pound would descend, not in a linear fashion, but in steps. Until, that is, the end-game becomes clear.
In a rational world the Europeans would realise early on that they will damage themselves by punishing Britain. But, alas, people who describe their philosophical systems as “rationalist” are never rational.
Reports of Sterling’s death have been exaggerated
I wrote back in March that the demise of Sterling has been one of the most oft-predicted economic themes of my lifetime. My grandfather (born in the early 1880s – a South London tram conductor) used to call a pre-decimal[i] half-crown coin (worth the equivalent of 12.5 new pence) a half a dollar – because, for most of his lifetime the Pound Sterling was worth four dollars.
After WWII the US Dollar displaced Sterling as the pre-eminent global reserve currency and the Pound declined to below US$3.00. In Harold Wilson’s famous Pound-in-your-pocket devaluation of November 1967, the value of the Pound was cut from US$2.80 to US$2.40.
In August 1971 came the “Nixon Shock”. The US government unilaterally cancelled the convertibility of the Dollar into gold (at a rate of US$35 per ounce) which had obtained since the Bretton Woods agreement of 1944. Thereafter, the major currencies were left “to float” in a sea dominated by Foreign Exchange (FX) trader sharks. The modern FX market, the boys in braces yelling two-way prices into phones, was born.
During Mrs Thatcher’s time in Downing Street the Pound oscillated between US$2.00 and, for a brief moment in the mid-1980s, near-parity. As I write, Sterling is at US$1.2318 and at €1.1230 (the Pound has responded well to Mr Hammond’s statement to the House of Commons Committee).
So today, Sterling is worth 31% of its US Dollar value in the year of my grandfather’s birth 133 years ago. The French Franc, as I wrote in March, by the time it was put out of its misery in 1999, was worth 0.03% of its 1880 value[ii]. (Most other European currencies, like the Spanish Peseta, and the Italian Lira suffered even more humiliating devaluations.)
Since the Euro became a “real” currency on 01 January 2002, Sterling has ranged from €1.54 to €1.04 in early 2009. This nadir was about the time that EU President Barroso declared that the Credit Crunch was purely an Anglo-Saxon problem. Note that the mistake the FX market made then was to presume that, because the UK was affected first, it was a uniquely UK problem.
Similarly, the markets currently think that Brexit is a purely UK problem, when in fact it’s a largely European problem.
A market without a valuation model
Let’s just step back one moment from the fray. The FX market works quite differently to other financial markets such as the equity and bond markets. The equity markets, imperfect as they are, use all available information (brokers’ reports etc.) to try to price the value of a share by reference to its future earnings potential.
In financial theory, the price of a share at any one time is the net present value of all future earnings (dividend payments and final capital gain) derived from holding that share, discounted at a rate equal to the opportunity cost of capital plus an appropriate risk premium.
Obviously, individual equity investors don’t make individual buy or sell decisions in this way – after all, they don’t know what the future dividend payments on a share and its final sale price will be. But the market as a whole, unconsciously, acts in a rational way; albeit buffeted by short-term bouts of fear and greed.
Now the FX market does not work according to any such theoretical pricing model. It simply responds to “news flow” – positive or negative – which, like social media, is rebarbative, selective and self-reinforcing. FX dealers don’t buy or sell because they have done fundamental research; they buy or sell because each gobbet of news they digest comes with either a green or a red light.
When I was in the City, the FX dealers were unkindly known as pond life. Of course that’s unfair. But you could probably train a prize Tamworth porker to be a competent FX dealer (and it would save you a lot of money).
By the way, Purchasing Power Parity (PPP) is not a currency pricing model. It’s just a comparator of price levels in different countries. The Economist magazine’s Big Mac Index has been misunderstood (and over-rated). Of course a Big Mac is more expensive in Tokyo than in Dhaka: rents and wages are obviously higher there.
Most currencies are normally mispriced; unless you adhere to the view the market price is always the right one – in which case all trading is futile. Nations with significant trade deficits can and do sustain stable currencies over long periods; and vice versa. The main action in the FX market takes place when sentiment changes in a particular direction.
Devaluation unfolds in easy stages
So, coming back to the outlook for the Pound, we can discern three recent stages which point to what is going to happen next.
The first stage, in the run-up to the UK-EU referendum of 23 June, the Pound, although already perceived as overvalued, was bid higher by speculators who never speak to ordinary people in pubs. As I wrote at the time, seeing Sterling hit nearly US$1.50 in the evening of 23 June, I wondered what the FX traders were on.
The second stage was the period from 24 June to 05 October when Sterling traded in a generally narrow band around US$1.2950-US$1.3250. This was the period of the Phoney War where the American and European elites could not bring themselves to believe that an ancient nation could defy the prevailing economic orthodoxy.
The elites imagined that, somehow, there would be a “fix” of some kind, just as recalcitrant EU members such as Ireland and Denmark were always required to reconsider adverse referendum results in the past. (Stunning arrogance, I know.)
The third stage followed Mrs May’s address to the Tory Party Conference on 05 October. As I predicted last month, Mrs May plotted a course towards the repeal of the European Communities Act, 1972 within the lifetime of this parliament.
The Prime Minister also finally revealed that Article 50 would be triggered before the end of March 2017. And she made abundantly clear that Britain would take back control of its borders. The European elites were taken aback – even horrified. (I really don’t know what French and German diplomats do all day if they couldn’t predict this one.)
The following evening, 06 October, President Hollande, Chancellor Merkel and “President” Juncker all made speeches within an hour of one another with the same message. If Britain did not accept freedom of movement she could not be in the Single Market.
Now I have discussed before the complex semantics here: being in the Single Market and having access to the Single Market and so forth. But the point is – as winter follows autumn – the Tamworths began choking on their truffles. On the morning of 07 October, there was “Flash Crash” in Tokyo with Sterling falling to a smidgeon below US$1.20.
The UK Remainiac media – the BBC, The Financial Times, and The Economist – attributed the Flash Crash to “Fat Finger Syndrome” – that’s when a cocaine-crazed Tamworth presses the zero key too many times (it happens quite often).
Of course it was nothing of the sort. It was an organised attempt by the Europeans to bring about what the American money guru Jim Rickards calls a Currency War. It was a coordinated attempt to weaken the UK’s negotiating position – and nothing to do with the “real” value of the currency (whatever that is).
Since 11 October the Pound has traded in a narrow range: from US$1.21219-1.23079. What will the fourth stage look like, and beyond? Of course, there is more hysteria to come – and much of it from the UK side with the Remainiac majority in the House of Commons in a contrarian mood.
The vultures, certainly, are circling. Everyday billionaires like Jim Rogers and Bill Bonner have signalled they are shorting the Pound and expect it to go below parity with the Dollar. They could be right: sentiment could trump common sense, as very often it does in the FX markets.
A problem is an opportunity
We in the UK have to rebalance our economy. Although we score well on growth and jobs relative to our European neighbours, we have become too dependent on foreign inputs, foreign labour and foreign capital and we have allowed productivity to lag. At the end of the day, the value of the Pound will be determined by market confidence – and the ultimate key to that is the confidence of the British people in their own future.
On Black Wednesday – 16 September 1992 – Sterling fell from DM 2.90 to DM2.35 – a devaluation of 19 percent in one day – despite massive currency purchases by the Bank of England and attempts to raise interest rates (for a few hours) to 15 percent. Only George Soros and Jim Rogers came out smiling.
Yet after Sterling’s exit from the ERM the British economy finally rebounded from a stubborn recession. On the British side, the experience left an indelible impression. On the European side the notion grew that Britain was a difficult customer. They were right.
In due course it will become apparent that Brexit offers the UK the opportunity to reduce negative regulation (I am certainly not against good regulation) and to pursue more pro-active trade relations with old friends like Australia and Canada as well as with dynamic up-comers like India.
Right now, I am more worried about the condition of national finances than about the exchange rate. (You’ll have to wait for the November MI magazine to find out why. Clue: Jim Mellon told an audience of German plutocrats in Munch last night that the collapse of the Euro within five years was “a certainty”.)
What the Bank of England should have done over the summer was to increase interest rates in anticipation of downward pressure on Sterling and resulting cost-push inflation. Instead, the Old Lady cut rates from 0.5 percent to 0.25 percent. A rate rise would have stimulated savings and therefore investment, and would have been a step back towards monetary “normality”.
How did we get here?
Let’s remember that the main reason for staying out of the Euro was to maintain an independent monetary policy and a flexible exchange rate. But the latter is a double-edged sword: we have to take the rough with the smooth.
Similarly, the main reason for voting to leave the EU was the opportunity to retake control of social and economic policy. There will be a price to pay for that; but, once paid, there will be rewards – one of which is not to be shackled to the mast of a sinking ship, as I will explain shortly.
I wrote in March: My best guess is that, one year hence, Sterling-Euro will not be dramatically different from where it is now, trading in the €1.20-€1.30 range – though the US Dollar will have advanced further against both the Pound and the Euro.
Seven months later, with a hard Brexit looking more likely, that was probably a bit optimistic, though not silly: it is likely to take longer for Sterling to recover; but with so much bad “news flow” for the Euro on the way, recover it will.
[i] The UK decimalised its currency in 1972, going from £1 = 20 shillings = 12 pennies to £1 = 100 “new pence”.
[ii] One French Franc was worth US$3.95 in 1880. In 1960 De Gaulle converted Old Francs into New Francs at a rate of 100:1. On 01 January 1999, the Franc was converted into Euros at a rate of €1 = NF 6.55957 while the Euro-Dollar rate on that day was US$1.1686. I therefore calculate that the value of the Old Franc in Dollar terms was US$0.001305, or 0.03% of its 1880 value.