by Simon Derrick
Although it is now over 40 years old, the BBC’s satirical television series “Yes, Minister” – reputedly Fredrick von Hayek’s favourite programme – can still provide useful insights into the relationship between UK politics and financial markets.
One of the standing jokes in the series was that senior politicians would always turn the TV news off just as the presenter said, “sterling had another bad day on the foreign exchanges.” This reflected the view that allowing GBP to take the strain (rather than local markets) had often been the default option for politicians over the previous fifty years, most notably in 1931 when the UK abandoned the gold standard and in 1967 when Prime Minister Harold Wilson’s government had devalued GBP against the USD by 14%.
This is not to say that the UK authorities did not intermittently try to defend GBP. Perhaps the most notable of these attempts, and one that arguably has coloured political thinking in the 30 years since then, was the attempt to defend the currency’s position within the European Exchange Rate Mechanism in 1992 with a combination of intervention in the FX markets and punitive interest rates.
By September 16th of that year the UK government faced a stark choice. By continuing to defend the currency’s position within the system it risked imposing an increasingly inappropriate monetary policy on an economy that was struggling to deal with the aftermath of a major housing market boom, as well as an exchange rate that was simply too high.
Moreover, investors were well aware of this problem and were not willing to wait to find out what happened next. The decision for the government was therefore between defending an indefensible exchange rate while watching local markets and the economy come under increasing pressure, or simply letting GBP fall thereby releasing the pressure on the economy.
In the end, the choice was a very easy one. By 7pm that evening, Norman Lamont, UK chancellor of the exchequer, had announced that the UK had left the ERM while the base rate returned to 10% the next day (having been briefly hiked to 14%). While GBP might have fallen sharply on September 16th and continued to lose ground over the next few days, this was more than matched by a rally in the FTSE 100 as investors applauded the emergence of more appropriate exchange rate and monetary policy settings. By the end of the week, the equity index was up 12% from the lows seen on September 16.
The autumn of 2007 proved the start of GBP’s next crisis when Northern Rock became the first British bank in 150 years to suffer a bank run after having had to approach the Bank of England for a loan facility. Although a full-scale GBP collapse would have to wait until the banking crisis of autumn 2008, the currency struggled to make any further gains after the news broke. Overall, the peak to trough decline in GBP in 2007/2008 against the USD was 34%, against the EUR around 36% and against the JPY around 50%. Once again, the UK authorities proved relatively sanguine about this decline, nimbly avoiding any detailed public discussion of the topic.
A similar pattern emerged in 2016 following a tumultuous few days for GBP in the aftermath of the Brexit vote. The then Governor of the BOE, Mark Carney, noted that “the adjustment in GBP, which has been significant … and sharp in the initial period, in fact, volatility spiked to its highest level ever, but that adjustment has moved in the direction that is necessary to facilitate some of the economic adjustments that are going to be required in the economy.” This was as clear a signal as any that GBP weakness continued to be tolerated as long as it didn’t destabilise domestic markets.
Yet again there appeared to be some justification for taking this pragmatic stance. Although following the vote GBP experienced its greatest daily fall against the USD (more than 8%) since the devaluation of 1967, the decline in the FTSE 100 was rather more modest when compared with previous falls. Indeed, the 3.1% decline in the benchmark was not even the sharpest fall seen that year.
So, what might this tell us about official attitudes both on Threadneedle Street and in Westminster towards GBP’s current weakness? The first thing to note is at least one voice within the BOE’s Monetary Policy Committee has been raised this summer to express concern over the threat of imported inflation. However, while the Bank has moved towards raising interest rates in 50bp increments, its own dour economic forecasts (along with signs that the UK housing market may have peaked) have done much to blunt the positive currency impact this might have had.
It’s also clear that the new Prime Minister Liz Truss will have other things than GBP on her mind now that Parliament has returned from its recess, extended due to the death of Queen Elizabeth II. Top of that list will be the fact that the next general election must take place by January 24, 2025. With recent polling showing the Conservative Party trail Labour by around 10 percentage points and political betting increasingly favouring Sir Kier Starmer as PM after the next election, the pressure will be on her to formulate aggressive and popular fiscal policies in order to reverse this trend.
Unfortunately, that is exactly the opposite of what the Office for Budget Responsibility is calling for right now, arguing that tax rises or spending cuts are required to avoid an “unsustainable” public debt burden. Moreover, the risk is that an aggressive spending programme allied to tax cuts over the months ahead could further feed into inflation, forcing the BOE to hike even more aggressively. This, in turn, would only increase the threat to the UK housing market at a time when prices already look dangerously inflated.
So how far can GBP move? During its collapse against the USD in 1981 and then again in both 1992 and 2008, the currency managed to lose 25% or more over a six-month period while in 2016 the June to October decline was around 20%. Even more minor moves (1975, 1976, 1989, 1991, 2010) saw declines in the region of 15% over a period of half a year. In other words, when GBP moves it really moves.
There is one final point to be made. GBP volatility has demonstrated a reasonable degree of seasonality over the years with late July and August often proving quiet – reflecting both the Parliamentary recess and the vacation period in financial markets – only to be followed by a quick pick up as Parliament returns. It therefore wouldn’t be surprising were this pattern to repeat itself this year with a stormy autumn ahead.