Sterling’s Drop to Parity With the Dollar Is a Growing Risk
British politicians have a complicated relationship with the pound, which has a complicated relationship with the US dollar. Currency crises, as governments tried and failed to defend sterling against the dollar, cost Harold Wilson and John Major their premierships, and once even appeared to end the political career of Winston Churchill. Now, the notion of parity to the dollar is being openly discussed after the pound staged yet another dive, while the government of Boris Johnson struggles with a crisis in the cost of living. Can sterling’s slide be stopped, and what would be the repercussions of a pound worth less than a dollar?
It’s a serious question. Fixed at an exchange rate of more than $2 until the end of the Bretton Woods regime in 1971, the pound nearly touched parity once before, in early 1985. Higher bond yields in the booming US economy, as the aggressive monetary policy of Paul Volcker at the Federal Reserve brought inflation under control, attracted funds out of the UK. A steady decline for sterling famously turned into a rout after a press briefing given by Margaret Thatcher’s press secretary Bernard Ingham made it sound as though the market could make a one-way bet against sterling. The Times’ headline, from Ingham’s unattributable comments, was: "Thatcher ready to let pound equal dollar."
She wasn’t. The Bank of England started increasing rates to defend the currency, and the pound’s slide stopped at $1.05. Since then, sterling has continued to endure some wild swings, without ever seriously threatening parity, and only briefly dropping below $1.20 at the height of the political crisis after the Brexit referendum of 2016 and in the early days of the pandemic two years ago. Now parity is in discussion again.
By the close of trading on Wednesday, sterling stood at $1.2251, a low it hadn’t seen since May 2020 when the first shocks of the pandemic were still being felt. Round numbers matter a lot in currency trading and so the next key psychological level will be $1.20. Since sterling’s all-time low in 1985, the pound has only dipped below this level during the worst of the political crisis over Brexit, and during the first days of the pandemic.
Those incidents centered on radical uncertainty about risks that markets find it hard to measure. This time, the crisis of confidence is driven simply by the core issue of foreign-exchange markets: traders fear that high inflation and weak economic growth will make it impossible to prop up the pound any further. And, as with the Bernard Ingham incident in 1985, the words of politicians and central bankers will also be critical.
This time, it is measured words from the central bank that have sparked the run on sterling. The Bank of England’s bold prediction last week that the inflation rate was heading above 10% while the economy is headed for recession came across as a “Volcker Moment.” Like Volcker at the Fed some 40 years ago, the BOE was admitting that inflation was out of control, and declaring its intent to inflict a recession on the economy to get it back under control.
The problem is that BOE’s big pronouncement had the exact opposite effect of the original Volcker Moment. To quote Marc Chandler, the chief market strategist at Bannockburn Global Forex in New York, “The BOE’s Volcker Moment crushed sterling. You have to be careful about what you wish for. They say that central banks raise rates until something breaks, and the Bank of England is saying that something’s going to break - the economy.”
The message the market has taken is that the BOE will not be able to raise rates many more times, while in the US the Fed is still sticking to the idea that it can raise rates throughout the year without killing the jobs market. The bond market shows that traders are inclined to believe the Fed, but not the BOE. British gilts usually offer a higher yield than US Treasuries. This helps protect sterling by making British deposits more appealing. But since the Brexit referendum, gilt yields have regularly traded below their US equivalents. This weakens sterling:
Usually, it is good politics to blame foreigners at times like this. Harold Wilson blamed his 1968 devaluation, when the Bretton Woods era of a dollar tied to gold was still in force, to the “Gnomes of Zurich.” Hungarian hedge fund manager George Soros took the blame for sterling’s collapse on “Black Wednesday” in 1992 after he successfully bet that the BOE could not raise rates high enough to maintain its peg to the deutschmark — and has been demonized on the right of international politics ever since.
This time, however, the politics of the pound are dangerously intermingled with the politics of Brexit. The referendum in June 2016 prompted an overnight drop of more than 10%, and the currency has never managed to regain the territory it lost that night. Its June 2016 level has acted as an effective ceiling for the pound ever since. The international traders who set exchange rates seem convinced that Britain’s exit from the European Union and its single market leaves its currency more vulnerable:
There are arguments that Brexit has left the UK more vulnerable to the whims of international capital but such an argument involves admitting that Brexit was a mistake. The slogan of Brexit campaigners was to “take back control,” but the current run on sterling suggests that the UK now has less control over its currency.
Furthermore, there’s a good argument that Brexit directly stoked the inflationary pressure that is now afflicting the British economy. Ian Harnett of London’s Absolute Strategy Research Ltd points out that the Confederation of British Industry’s quarterly surveys of businesses about the impediments to their output work as a great leading indicator for inflation. When there is a rise in the proportion of companies saying they expect labor shortages to dampen their production over the following three months, then inflation rates tend to rise a year later; tight labor markets force companies to raise wages which they then pass on in the form of higher prices. Very ominously, the CBI now shows that labor shortages are the most serious since the stagflationary days of 1973:
Brexit probably has much to do with this. The EU used to be a bounteous supplier of cheap labor to the UK. That led to the negative social consequences that came to a head in the referendum, but also kept a lid on inflation and supported the pound. Now, the CBI says there’s a “perfect storm” disrupting companies’ attempts to adapt to the new immigration system. The pandemic made this harder, and also led their EU workers to leave the UK to be closer to family. The result is an acute labor shortage.
Parity against the dollar would make imports more expensive and deepen the UK’s inflation problem still further, but at this point it’s hard to see what the UK can do about it. Sterling’s fate is left in the hands of the US. Can the dollar’s strength really continue, and can the Fed really be as aggressive as it says before coming up against its own economic constraints? Many other countries around the world have heavy dollar-denominated debt, while US multinationals will dislike the way a strong dollar shrinks their overseas profits.
The last time the dollar grew this strong, such concerns provoked pressure on the Reagan administration to weaken the currency. It did just that with the so-called Plaza Accord of 1985, in which it agreed with other countries on intervention to limit the dollar’s rise. The pound profited. This time, as then, parity can probably be avoided, but only because it will be in US interests to avert it.
After Bretton Woods ended in 1971, Richard Nixon’s Treasury secretary John Connally told other finance ministers that the dollar is “our currency and your problem.” That continues to be the case.
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