Every now and again someone – often Kamal Sharma from Bank of America (BofA) – warns that sterling is at risk of being downgraded to ‘emerging market’ status. This is lapped up and gleefully retweeted by anyone with an axe to grind against Brexit, or Boris Johnson.,,
However, as Sharma himself rightly said in his latest note, ‘timing is everything’.
The last occasion BofA made a big splash with the same story was in June 2020, when the pound was worth around US$1.23. It then rallied steadily to peak above US$1.40 in May 2021. Indeed, the original story was swiftly countered in the FT itself…
Now the pound is back at similar levels against the dollar (around US$1.25), so I guess it was about time this story resurfaced. Sterling has also been one of the weakest of the major currencies so far this year.
However, the pound is not alone in coming under pressure this year: the Japanese yen, Norwegian krone and Swedish krona have also posted significant falls against the US currency. This is still primarily a story of dollar strength. The pound has recently weakened against the euro as well, but remains about 5% stronger on a trade-weighted basis than it was in June 2020. (The chart below shows the Bank of England’s sterling effective index.)
So, what’s going on? First, this is mainly about expectations for interest rates. The US dollar has been strong because investors have been predicting that the Fed will raise rates further and faster than other central banks.
This has been compounded by ‘safe haven’ demand following Russia’s full-scale invasion of Ukraine. It helps too that so many global commodities are priced and traded in the US currency.
Until recently, the Bank of England was expected to raise rates more aggressively than the ECB, which lifted sterling against the euro. In recent weeks this has flipped over, partly because eurozone inflation has risen much further than most had anticipated.
The crucial point is that this is all standard stuff for the currency of any advanced economy. Speculation about growth and inflation differentials, and central bank ‘reaction functions’, is par for the course. Every currency is vulnerable to political uncertainty.
Where, then, does talk of an ‘emerging market’ currency come from? No-one (at least, no-one remotely credible) is arguing that the UK economy itself will become an ‘emerging market’.
Instead, the suggestion is that sterling might behave like an emerging market currency, in terms of its volatility, or liquidity, or greater sensitivity to institutional weaknesses such as political risks.
This is nothing new. Bloomberg ran a similar story in 2016, asking whether the British pound is now the ‘new Mexican peso?’. The correct answer, of course, turned out to be ‘no’.
When he was Bank of England Governor, Mark Carney (unhelpfully) suggested in 2019 that sterling volatility was at ‘’emerging market levels”, and that the currency had “decoupled” from its peers. But this was a time of peak concerns about a ‘no deal Brexit’, and the pound has since recovered.
The new developments more recently are the possibility of a vote of ‘no confidence’ in Boris Johnson, and concern about the credibility and independence of the Bank of England. These may well create some additional volatility – both up and down – but this is hardly unique to sterling. Any currency, developed or emerging, is likely to be more volatile at election time.
It is debatable too whether the Bank of England has actually lost more credibility than the Fed or the ECB, given that inflation is now above 8% in the UK, US and eurozone, while official interest rates are still near historic lows in all three regions. Indeed, the Fed and the ECB have also come in for a lot of criticism.
In the meantime, sterling remains an international reserve currency: according to the IMF’s COFER database, the pound’s share has remained steady at nearly 5%, not far short of the Japanese yen’s 5.5%, and more than the combined total of the Canadian dollar, Australian dollar and Swiss franc.
And unlike actual emerging markets, there is no pressure for the UK government to borrow in any other currency than its own.
For what it’s worth, I expect the UK economy to hold up better than most are predicting this year, with the peak in UK inflation to be both lower and sooner than the markets are anticipating. A combination of looser fiscal policy and tighter monetary policy should also help sterling to recover some ground. The recycling of BofA’s old warnings might even be a ‘buy’ signal!
To be clear, I’m not really having a go at Kamal Sharma here. His latest note is reasonably argued and sensibly caveated – and he’s just doing his job of flagging up risks to clients. Other strategists, notably George Saravelos of Deutsche Bank, have raised similar concerns about the outlook for the pound.
I don’t blame busy journalists from running with this story, either, especially in a holiday-shortened week. But others should stop and think before piling in. Simply ‘googling’ whether this has all been said before might be a good start, especially if your own newspaper has already debunked it…
Plain-speaking Economics 