Pound hits new low – what does it mean as dollar parity nears?
- British pound plunges to $1.03, lowest since 1971 and nearing parity with the dollar
- I have been writing all year that the dollar will continue to strengthen in the current environment
- UK mini-budget proposing tax cuts last week has provided investors with extra reasons to sell GBP
Yikes. It was not too long ago that the euro hitting dollar parity made big news, which I wrote about at the time here. As the graph below shows, the collapse of the euro against its transatlantic counterpart has been pretty spectacular, with one euro now only able to net you 97 cents.
But today, it’s the pound making the headlines. As unbelievable as it is to say, it’s not beyond the realm of the possibility that we could soon get pound-dollar parity, as the pound this morning hit a $1.03, the lowest since 1971 – when a new paradigm of international exchange rates was ushered in as US President Nixon abolished the gold standard.
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The exchange rate has rebounded slightly as I write this to $1.07, but it’s still a massive drop and any dreams for British tourists to be walking down 5th Avenue in New York for a little holiday have likely been put on hold. The chart below paints a grim picture of how stark the sell-off is in historical terms.
Why is the pound so bad?
The latest plunge comes in response to new Prime Minister Lizz Truss’ administration announcing a new UK mini-budget. A host of tax cuts and spending measures have caused concern among investors at the sustainability of the UK economy.
The UK current account deficit, which is a log of exports minus imports, was already at record levels before this latest plunge in the pound. The energy crisis – UK is reliant on energy imports – had already been putting the balance of payments under pressure. This latest blow will do nothing to quell the sell-off in the pound.
I thought Sanjay Raja, chief UK economist at Deutshe Bank, had some comments that were on the ball about the balance of payments threat, saying that the inflationary pressures of the tax cuts would raise “the risk of a near-term balance of payments crisis”.
A plan to get the public finances on a sustainable footing will be necessary but not sufficient for markets to regain confidence in an economy sporting large twin deficitsSanjay Raja, Chief UK Economist at Deutsche Bank
Why is the dollar so strong?
This is just the latest strike down in the pound’s exchange rate. More aggressive hiking of interest rates in the States has seen capital flow into the dollar to take advantage of the increased yields on offer.
Moreover, the dollar repeatedly strengthens during turbulent times, something I have written about several times this year. In addition to the piece linked in the opening line analysing the euro/USD rate, I also bemoaned how I was feeling the brunt of the greenback strength when I holidayed in Ecuador last month, who use the US dollar (it was worth it- those volcanoes are something else…).
The below chart from Darqube shows that the DXY Index, which measures the dollar’s strength against a basket of foreign currencies, is up 18% on the year so far.
This is typical of turbulent economic periods. When uncertainty floods markets, investors move to safe-haven assets, and there is no safer currency in the eyes of investors than the US dollar. I plotted the DXY index historically, and the upwards moves in times of recessions are clear.
What does this mean for UK markets?
The fallout from the pound’s plunge against the dollar is likely to hit the stock market. It already has, really, with a sell-off into the closing bell Friday. While exports to the US will be cheaper for American consumers and hence benefit UK stocks, the flipside is also true regarding imports being more expensive for British companies.
However, it is really the reaction of the Bank of England that will trigger the stock market one way or another. Some analysts believe interest rates will now be hiked more aggressively than previously expected, in order to protect the pound. If this scenario transpires, this would suck liquidity out of the market, further raise discount rates used to value the future cashflows of companies and ultimately negatively impact the stock market.
Therefore, for the time being, all eyes will be on the Bank of England’s reaction to Lizz Truss’ mini-budget and the consequent pound sell-off.
But no matter what way you swing it, we live in a dollarized world. As the music stops on the historic 10-year financial market bull run, I’ve been warning all year that the only currency you want to hold is dollar. I’m not changing my position now, even as pound/dollar parity nears. Europe is in a worse place economically than the US, and the winter ahead will be very tough for all of us here on the Continent.