The UK was a very different place the last time the pound was worth so little against the dollar. It was 1985, and Vodafone had just launched the UK’s first mobile phone network, football hooliganism was rife and the Anglo-Irish Agreement had laid the groundwork for devolved government in Northern Ireland more than a decade after a previous power-sharing executive had collapsed.
Fiscal stimulus plans have raised questions about the financing of the UK’s twin deficit, also affecting the pound negatively
Thanos Vamvakidis, BofA Securities.
In the financial system, the Bank of England (BoE) did not have operational independence and there were monetary aggregate targets in place.
But there are also similarities between then and now. This year’s industrial unrest mirrors the bitter miners’ strike that ended 37 years ago. A Conservative government lags in the opinion polls, as it did in 1985. And inflation is high.
In the US, high interest rates, expansionary fiscal policy and a strong economy fuelled a dollar bubble that was only deflated by the 1985 Plaza Accord – an agreement between France, Germany, the US, the UK and Japan to manipulate exchange rates by depreciating the dollar relative to the yen and the Deutschmark.
Unfortunately for the UK, in 2022 there is little prospect of a similarly coordinated policy response to weaken the dollar. The government’s apparent readiness to deploy a large fiscal package could lead to increased risk premia on sterling assets, while weak domestic demand compared with the US means the asset allocation outlook is not favourable.
“In addition, continued Brexit-related uncertainty and disagreements about the implementation of the Northern Ireland Agreement add to sterling risks,” says Thanos Vamvakidis, global head of G10 FX strategy at BofA Securities. “Fiscal stimulus plans have raised questions about the financing of the UK’s twin deficit, also affecting the pound negatively.”
A research note on Thursday from BNP Paribas stated that the UK is particularly sensitive to external developments, given the openness of its economy and its reliance on foreign financing to fund the large and persistent current-account deficit. Global economic uncertainty and relatively low levels of real yields may see cross-border portfolio flows slow, leaving UK assets particularly vulnerable.
On the same day, HSBC flagged the possibility of a more hawkish BoE in the medium term, after a seventh successive rate hike. However, European FX strategist Charlotte Ong said she was unconvinced that this would be enough to change sterling’s fortunes.
Japan
There are also common factors between Japan today and in 1998 – the last time the yen was as weak as it is now.
“The Bank of Japan (BoJ) had very loose monetary policy in comparison to the Fed and the Bank of England at that time,” explains Paul Mackel, managing director, global head of FX research at HSBC. “The theme of policy divergence is similar to today and the yen carry trade has become popular again.”
Questions are certainly being asked about the sustainability of Japan’s current policy path
Geoffrey Yu, BNY Mellon
However, Japan was also running a massive trade surplus on the back of its manufacturing boom 24 years ago, while rates were low, reflecting weak domestic demand. The resulting imbalances contributed significantly to the establishment of the Plaza Accord.
BoJ governor Haruhiko Kuroda’s steadfast refusal to acknowledge domestic-based inflation pressure is highly distortive, says Geoffrey Yu, FX and macro strategist for EMEA at BNY Mellon.
“The Japanese economy has not changed much from underlying trends, so compared to the UK there would seem less of a problem surrounding a sudden decline in growth expectations,” he says. “However, questions are certainly being asked about the sustainability of Japan’s current policy path.”
George Saravelos, Deutsche Bank’s global head of FX research, notes that GBP and JPY have suffered more from the flight to dollar cash and global risk aversion because both currencies have very low real yields.
Standard Chartered’s models suggest momentum and a USD overshoot are also factors, according to Manpreet Gill, the bank’s chief investment officer for EMEA and head of fixed income, currencies and commodities strategy.
Another common source of depreciation pressure for GBP and JPY is the impact of higher energy prices and the negative impact to the respective balance of payments
Paul Mackel, HSBC
“Another common source of depreciation pressure for GBP and JPY is the impact of higher energy prices and the negative impact to the respective balance of payments,” adds HSBC’s Mackel. “The difference is that the Bank of England has been tightening monetary policy while the Bank of Japan has kept a dovish policy stance.”
Another factor that distinguishes 2022 from 1998 is that in the late 1990s the spread between US and Japanese yields was even wider than it is today. “This reflected the fact that even before the Fed embarked on a hiking cycle in 1999, rate spreads already strongly favoured the US,” says Alex Jekov, FX strategist at BNP Paribas.
Elliot Clarke, senior economist at Westpac, agrees it is notable that the yen has depreciated sharply against the dollar, despite a significant fall in price of oil and Japan’s economy experiencing a strong rebound in activity through mid-2022. The weakness stems from the BoJ holding policy rates at the lower bound and persisting with open-ended quantitative easing (QE).
The yen’s fall to its lowest valuation since 1998 was met with direct action from the Japanese authorities, who began selling dollars on Thursday. The move surprised analysts, as it is at odds with BoJ policy.
Saravelos at Deutsche observed in a research note that unilateral intervention on the same day of a dovish BoJ meeting speaks to significant internal contradictions. When Japan last intervened to defend the currency in 1998, the US-Japan interest-rate differential was moving sideways instead of sharply higher as it is today.
Deutsche is also sceptical that using dollar reserves to buy yen will do anything more than reduce some speculative positioning in the short term and warns that if authorities were intent on intervening by more than symbolic amounts, reserve depletion could build quickly.
