There’s something odd about the latest fall in sterling that has taken the currency down to close to a 10-year low against the euro and 34-year low against the US dollar. It’s that this has happened at a time when something should in theory be helping support the pound.
This something is the prospect of looser fiscal policy. Mr Johnson has promised increased spending on schools, hospitals, police and infrastructure as well as tax cuts. This should support sterling by fuelling expectations of higher interest rates. This isn’t because increased government borrowing causes gilt yields to rise; it doesn’t. It’s simply because the Bank of England thinks (rightly or wrongly) that the economy already has little spare capacity. As Bank governor Mark Carney said last week, this means that any pick-up in economic activity will lead to “sharply rising excess demand”. And this in turn means higher interest rates – which should support sterling.
Conventional macroeconomics – in the form of the Mundell-Fleming model – tells us that looser fiscal policy strengthens exchange rates; it is one reason why the dollar has appreciated since President Trump’s fiscal loosening.
Why, then, is sterling so weak? At one level, the answer is obvious. The threat of a no-deal Brexit has increased, and markets believe the damage this will do to the economy outweighs any benefit of looser fiscal policy; the notion that the economy can comfortably withstand no-deal has much more credence in the media than it does in the markets.
We see this clearly in interest rate futures prices. These are now pricing in a three-month interbank rate of 0.56 per cent in December 2020, implying a quarter-point cut in Bank rate by then. As recently as May, they were pricing in a rate of over 1 per cent. The market therefore expects the Bank of England to respond to no-deal by cutting rates. And this prospect has spooked the pound.
But it is just that – a prospect. As I write, Betfair puts the chances of no-deal at less than 40 per cent. And Mr Johnson’s talk last week of us staying in the single market until 2021 should remind us not to take it for granted.
For sterling, this is a two-edged sword. On the one hand, it suggests that no-deal is by no means fully priced in and so the currency could fall a lot further if it becomes so.
On the other hand, though, if markets start believing that the risk of no-deal is receding sterling would rise. And it could do so significantly if traders focus less upon Brexit and more upon the change in fiscal policy.
You might think this is horribly inconclusive. In one sense it is. William Goldman’s famous saying applies to Brexit: nobody knows anything.
It does, however, have a practical implication. It warns us that it is very dangerous to bet on sterling either way. We should never, ever, base our portfolios upon a forecast of exchange rates. By all means hold some foreign currency as a hedge against the potential damage that a no-deal Brexit would do to domestic businesses. But do not think it is a must-win bet. It’s not.
