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Cheap – for a reason

Sterling is cheap – but this might reflect the UK's poor growth prospects and the fact that the currency is riskier than others
February 18, 2020

Despite its recent rise, the important fact about sterling is that it is still low. If we adjust for differences in consumer price levels to get a measure of the real exchange rate the pound is 17 per cent below its post-1999 average against the US dollar and only slightly above the post-1985 low it hit soon after the EU referendum. And even against the euro – which has been weakened by the region’s negative interest rates and feeble economy – sterling is 4 per cent below its post-1999 average.

This matters. Exchange rates have behaved like share prices in one important respect: they have often overshot fair value and so become too cheap or too dear. Martin Eichenbaum, Benjamin Johannsen and Sergio Rebelo have shown that the real exchange rate has been a good predictor of subsequent changes in the nominal rate, with low real rates leading to rising nominal rate in the following months.

Recent history shows that this is true of sterling. Since 1996 the correlation between the real €/£ rate and the subsequent three-yearly change in the nominal rate has been 0.39. For the $/£ rate, the correlation has been 0.53. These might not seem very high, but given the volatility of exchange rates and the fact that many economists have found them to be otherwise unpredictable, they are significant.

This seems to suggest we should expect sterling to rise in coming months, and hence to see losses on some overseas investments.

Or should we?

There’s an obvious problem with this inference. Sterling could be cheap for a good reason because post-Brexit trade frictions will reduce long-term growth; the thinktank The UK in a Changing Europe estimates that this will reduce GDP by over 6 per cent by 2030 relative to what it would otherwise have been. This justifies a low exchange rate now because financial markets should anticipate lower real interest rates as a response to slower real economic growth.

Of course, markets do sometimes overshoot. But just as shares are sometimes cheap for a good reason, so too can be currencies.

If you want to be bullish of sterling, you must reject this argument. Can we do so?

One possible argument is that the job of supporting growth against the hit from Brexit will be done by fiscal rather than monetary policy. But we don’t know this yet: in particular, we don’t yet know whether the new chancellor will impose fiscal rules to restrain borrowing. If he does, monetary policy will stay loose.

Another argument is that the damage done by Brexit can be offset by growth-enhancing policies such as increased infrastructure spending.

Such optimism, however, runs into the problem pointed out by John Landon-Lane and Peter Robertson in 2003. They showed that, over the long run, developed economies tend to grow at similar rates. This, they infer, suggests that national governments can do much less than they think to stimulate longer-term growth.

But we can draw another inference from this – that economies are resilient to bad policies as well as to good. There’s considerable uncertainty about just how much damage trade frictions will actually do. While it’s plausible that slower growth in external trade will tend to depress growth, the magnitude of this effect is uncertain.  

Of course, such uncertainties won’t be resolved for a long time – if, indeed, at all because we will never see the parallel universe in which we did not leave the EU. But they do mean there is room for markets to slightly reappraise their pessimism, especially if some kind of post-transition trade deal with the EU can be struck.

We cannot, therefore, rule out the possibility that sterling might have overshot and so might bounce back.

Brexit and long-term growth, however, are not the only issues. Sterling is a risky asset – as we learned in the 2008 financial crisis it falls a long way in bad times. Buying sterling is therefore a bet that global investors won’t lose their appetite for risk. Even if sterling does rise, therefore, it would only be a reward for taking on risk. For retail investors especially, there is no easy money to be made in foreign exchange markets.