The global credit crunch and debt crisis have shattered previous notions of what is and is not considered a safe haven — and sterling is one of the biggest beneficiaries of this revolution.
In some ways it seems an unlikely candidate for safe-haven status.
Last week the U.K. officially entered a double-dip recession — where output starts to fall again before it has recovered from the last downturn.
Moreover, the government is running a deficit, which is even higher than the worryingly elevated advanced-country average — it was equal to 8.7 percent of gross domestic product last year.
Nevertheless, the pound has risen by about 7 percent on a trade-weighted basis since last July. At $1.62 against the greenback on Tuesday, it was up 10 cents, or 7 percent, from a mid-January low. It barely paused for breath on news of the recession — resuming its ascent within hours.
What accounts for sterling’s as yet unstoppable progress?
It is fair to say that the paltry growth of the U.K. economy over the past year — which may have fizzled out altogether — has disappointed many economists. However, the euro zone’s performance has been equally dismal, with most analysts expecting official figures to show the currency union has entered recession in lockstep with the U.K.
Moreover, investors are concerned less by the size of fiscal deficits — which can, if they persist, provoke currency crises — than by whether they are going up or down. The U.K.’s is gradually falling, and has even met the target for the 2011-'12 financial year set out by Chancellor George Osborne. The Conservative-Liberal Democrat coalition government to which Osborne belongs has no opportunity for back-sliding, having set out unwavering austerity as its overriding central policy and berated the Labour opposition for not being sufficiently parsimonious when in power. The credibility of the U.K. government’s austerity program contrasts with the lack of trust in euro zone governments such as Spain’s to press ahead with cuts sufficiently severe to close the fiscal gap.
Moreover, sterling enjoys one clear advantage over the euro — no one doubts that it will exist in five years’ time. This has helped push the pound 13 cents higher against the euro since July, to €1.23 — a key driver of sterling’s trade-weighted rise, since the euro zone accounts for half of the U.K.’s overseas commerce. Investors seeking currency safety in Europe outside the euro zone have flocked to the pound partly because of the lack of other options. Intervention by the national central bank sent the Swiss franc plummeting last year. The Norwegian crown is strong, but not sufficiently liquid for most institutional investors.
The pound’s rise has accelerated in the past few weeks on diminishing expectations for a further round of quantitative easing (QE) — which reduces the value of a currency by increasing its supply. Only one member of the Bank of England’s nine-person monetary policy committee (MPC) voted for further QE last month. The Bank of England is mindful that QE is inflationary, at a time when inflation remains stubbornly high in the U.K. — at 3.5 percent, it is 1.5 percentage points above target.
HSBC suggests in a recent note that sterling’s ascent may have been encouraged by a mathematical virtue. It does not correlate very much with either leg of the “risk-on risk-off” trade that is increasingly dominating financial markets, where international investors respond to changing daily perceptions about global economic prospects by buying and selling investments from an ever-widening range of asset classes. Many investors are actively looking for assets that are not part of this trade, because they think the risk-on risk-off phenomenon leads to blanket sell-offs that make well-researched investing based on firm, long-term convictions very difficult. In HSBC’s calculation, the S&P 500 is the ultimate risk-on asset, and the VIX index of stock market volatility lies at the other end. Sterling is planted bang in the middle, together with a small number of other assets such as gold.
Sterling’s happy isolation from the current dominant theme of institutional investment may not, however, last. It may be only a matter of time before this highly liquid, globally traded currency joins the risk-on risk-off complex, as more investors see it as a good proxy for global economic hope or despair. Through a self-fulfilling process, it will become a good risk-on risk-off trade almost as soon as investors decide it is.
Such a development, however, is unlikely on its own to deal a body blow to sterling. Of more concern to sterling bulls is the U.K.’s current account. Depressed by the U.K.’s trade deficit, the current account deficit is 2 percent of GDP. Jim Leaviss, fixed-income fund manager at M&G Investments in London, notes, “Typically, when the current account deficit has been greater than 2 percent of GDP we’ve seen significant corrections in the value of sterling against its trading partners.” Deficits reduce the value of sterling by lowering demand for it.
If the current account proves the cause of sterling’s downfall, the currency’s strength will have sown the seeds of its own destruction. When officials in the U.K. finance ministry and Bank of England pondered how to engineer economic recovery after the 2008 credit crunch, one of their central assumptions was that low interest rates would keep the pound low too, allowing Britain to export its way out of recession by boosting sales of competitively priced manufactured goods. Instead, the poor performance of manufacturing, hampered by the pound’s strength, has exerted a serious drain on the current account balance and on economic growth. It may, yet, damage the pound too.
