Business

How low can the pound go?

The pound will come back, the only question is when

BY Dominic Frisby   /  13 October 2016

It’s the oldest currency in the world still in use.

It’s the world’s fourth most-traded currency.

It’s the third-most widely held in foreign reserves.

And it has collapsed.

Today we discuss the demise of the Great British pound…

What sparked the sell-off in the pound

John, MoneyWeek’s editor, emailed me yesterday asking what I planned to write about this week. “Sterling”, I said.

“OK,” he replied. “It’s at $1.24, $1.23, $1.22 – never mind, the pound’s falling.”

By the time I replied it was at $1.21. And by the time he read the email it was at $1.20. The selling has been brutal.

There are several factors – in addition to Brexit – that have driven it lower, and they are worth mentioning.

First, there is the Bank of England’s decision in mid-September to cut interest rates and begin another round of quantitative easing (QE). The aim of low rates and QE is to weaken the currency and prop up asset prices – so the practice hurts those who rely on salaries, as well as savers, while benefiting asset owners.

Why the Bank of England would deliberately weaken the currency at such a vulnerable time, I cannot say. But the September sell-off began with its announcement.

The decision was unnecessary. The effect has been damaging.

Second, at the end of September, we saw the International Monetary Fund’s re-weighting of its Special Drawing Rights (SDRs). That sounds like wonk-speak. It is.

SDRs are, effectively, the IMF’s international reserve currency, made up of, until last month, the US dollar (42%), the euro (37%), the pound (11%) and the yen (9%).

However, on 30 September, to make room for the Chinese yuan, sterling had its weighting cut back to 8%. That’s a considerable cut. The yen and the euro also had their weighting cut, although not by as much on a proportional basis. The pound was the biggest victim of the cull.

For the record, the new weightings of SDRs are as follows: US dollar 42%; euro 31%; Chinese renminbi 11%; Japanese yen 8%; and pound sterling 8%.

It was well known in advance that this re-weighting would take place, which makes the Bank of England’s decision to slash rates and start up another round of QE a fortnight before the event even more baffling.

Then, of course, on top of it all we have the great unknown that is Brexit – how, when and on what terms. It is a step into the dark and it is spooking people.

So the pound is now in freefall.

What might arrest sterling’s decline?

On a purchasing power parity basis – in other words what a pound buys you here in the UK, compared to what it buys you on the continent or in the US – I’d say the pound was undervalued by maybe 20%. Using ballpark figures, $1.45-$1.50, and somewhere near the €1.30 mark seem like much fairer value to me.

But what seems like fair value to Dominic Frisby is an irrelevance. Markets will do what they do with no heed paid to whatever opinion I, you, or anyone else projects onto them.

Below is the long-term chart of the pound that has been my point of reference for so long. The simple stance has always been “buy” in the green zone, with a stop just below, and “sell” in the red. The yellow zone, resistance or support, is also a useful guide to time buys and sells, and place stops.

But after the Brexit vote, the green zone has given up the ghost. It will now be resistance, when the pound eventually stages a rally (which it will).

Chart of the pound v the dollar

It’s impossible to know where this will end. One possible target is the all-time low of $1.04, set in late 1984 during the miners’ strike. That low, it should be noted, was as much a function of US dollar strength as sterling weakness. It eventually had to be tempered with the Plaza Accord of 1985 to weaken the dollar.

Another target might be the low that was hit during last week’s flash crash. Different sources are giving me different data on what that low was, but the widely agreed figure is $1.18 – so there should be some support there.

The pound reversed a little overnight with the prime minister’s announcement that she will allow parliament to debate her Brexit plans, so, who knows, maybe yesterday was the low. I doubt it, though it certainly felt like a selling climax.

The Bank of England Monetary Policy Committee makes its announcement tomorrow. Do they eat crow and put up rates in order to stabilise the currency? My Twitter poll says no, and it does seem unlikely.

Data released on Friday from the futures exchanges showed that the short position in sterling is at record levels – meaning there have never been so many sellers of the pound.

The number will only have increased since then. Record numbers of sellers would indicate a market that’s closer to the end of its move than the beginning – and it means a lot of potential buyers when that trade reverses.

A stubborn value investor might now be saying: “Enough is enough. This is too cheap. I’m buying.”

But the momentum trader might be selling, even at these low levels, because the trend is down.

My stance – wherever possible – is to try to ignore my prejudices and let price dictate my actions. I’m finding that difficult at the moment, because the price of the pound is so political.

I was in favour of Brexit and remain so. I think the UK will thrive outside of the European Union, when we eventually leave, but we’re at that panicky, early stage in the divorce, when nobody knows what is going on, lawyers have to be found, nobody knows what kind of deal is possible, tentative letters of separation are being drafted and everybody is scared.

It makes it all very difficult.

My calls on sterling over the years have been pretty good. But this year I have been way off. Thank goodness for risk management. My instinct says this is a huge opportunity to buy the pound. Yesterday felt like at least a short-term selling climax – the pound has rebounded this morning.

But I can’t see a meaningful trend developing until we have a surer path ahead of us. So my outlook over the next few months is whipsawing and volatility.

The pound will come back. The question is when.

This article was originally published by MoneyWeek and can be read here