The UK takes a big gamble, but a sterling crisis is not inevitable
Currencies are the calling card of an entire country. Economic growth, inflation and political risk all have a bearing on a currency’s value. Judging by sterling’s 3.6% slump against the U.S. dollar last Friday, foreign exchange traders were decidedly unimpressed by the fiscal package announced by new UK chancellor Kwasi Kwarteng. The fiscal event was not treated as a regular budget, ostensibly to avoid having the independent Office for Budget Responsibility (OBR) produce updated fiscal projections.
There was certainly nothing timid about the budget measures, comprising the largest aggregate tax cut that Britain has seen since the 1970s. Analysis by the Resolution Foundation suggests that borrowing will rise by a stunning £265bn over the next five years, compared to the OBR’s forecast in March. The rise in public debt is due to the tax changes, combined with the energy support measures announced earlier, and accentuated by a weakening economic outlook. Bond investors immediately discounted the worsening fiscal outlook by driving up 5-year UK gilt yields by nearly 0.9% to 4.43% and 10-year yields by 0.6% to 4.07%, a spectacular two-day surge in long-term interest rates.
Many observers and think tanks including the Institute for Fiscal Studies (IFS) noted that a large share of the tax cuts would go to those on the highest incomes. The IFS also remarked that the tax cuts will need to be paid for by future tax rises or spending cuts, unless growth is higher than expected. Incoming UK prime minister Liz Truss and her chancellor are betting big that growth will pick up sufficiently to validate the break from the more fiscally conservative stance of their predecessors.
The slump in sterling had many market observers clamoring for ever more bearish predictions for the UK currency. Parity with the U.S. dollar seemed only a matter of time, given the overwhelmingly negative sentiment for sterling and the strong safe-haven appeal of the greenback.
As readers of the Russell Investments blog know, we look at every asset class through our proprietary cycle, value and sentiment framework. Let’s do that for the pound sterling after last week’s momentous budget.
Economists use the concept of purchasing power parity (PPP) to serve as a value anchor for exchange rates. The PPP exchange rate is the one that equalizes the cost of a representative basket of goods and services across two countries. If a currency trades significantly below its PPP exchange rate vis-a-vis the US dollar, it is said to be undervalued against the greenback. According to data from the Organization for Economic Cooperation and Development, the latest available PPP exchange rate for GBP/USD is 1.44. With GBP/USD trading at 1.08 as of Sept. 23, it suggests a 33% undervaluation. Currencies can and do diverge substantially from PPP and can take a long time to mean-revert, but the valuation analysis is supportive for the pound.
Economic and political factors can overpower the valuation pull in the short term. A standard macro model that incorporates exchange rates, the Mundell-Fleming model, predicts that an expansionary fiscal policy in a country will lead an appreciation of its currency. This occurs because the uplift in demand will drive up interest rates, thereby attracting capital from abroad. Why has this currency prediction of theory not played out in the case of a hugely expansionary UK budget last week? For one, there was certainly surprise and possibly shock about the size of the unfunded tax cuts and additional borrowing required. More importantly, markets were very concerned that UK policymakers may lose their anchors in terms of debt sustainability and commitment to inflation targeting.
Paul Krugman, the Nobel laureate and father of currency crisis economics, points out that there are two ways in which a country with floating exchange goes through a run on its currency. First, it may have large external liabilities denominated in foreign currencies. Present-day Turkey comes to mind, but this does not apply to the UK. Second, the market could suspect that the country is not able or willing to service its debt, for example by monetizing it. The latter route to a sterling crisis hinges on the central bank playing along. So, it is very much in the hands of the Bank of England whether it inflates away the UK’s debt and shatters bond investors’ faith.
An independent, inflation-targeting central bank would not go down that route. Kwasi Kwarteng reiterated his commitment to the independence of the Bank of England. In fact, a central bank worried about its inflation-fighting credentials would react to a demand-boosting fiscal package by raising rates more than previously expected. Markets are starting to price in a 100-basis-point increase at the next monetary policy meeting, which could contribute to shoring up sterling.
The momentum element of our sentiment building block could not be more negative for GBP. That could carry GBP/USD toward parity. However, when market consensus gets too strong and investors herd into a one-sided position, the risk is that the prevailing trend reverses. There are some tentative signs of this from positioning data in currency futures, as reported by the Commodities and Futures Trading Commission (CFTC). Speculative market participants have a 19% net short position in GBP as of Sept. 20, which presents a sizeable bet on the pound falling further. It is still too soon to say that the trend could reverse based on an extreme one-sided position, but we are getting closer.
The bottom line
Economists’ verdict on the budget were mostly scathing and the new prime minister and her chancellor are making a gamble on a pick-up in growth further down the road. In the short-term, downward pressure on the pound could persist, but it is in the hands of the Bank of England to stave off a currency crisis.