Weak UK economy ties Bank of England’s hands on FX intervention
New UK prime minister Theresa May is busy shaping her administration at 10 Downing Street, but it is events taking place barely two miles away, at the Bank of England on Threadneedle Street, that are exercising the minds of those trying to predict where the pound goes next.
The Bank of England's ability to intervene in sterling is hampered by weakness in the economy
The fall in the value of sterling against the US dollar and the euro over the past few weeks has heightened market volatility, increasing the cost of hedging sterling exposure and making the UK a less appealing proposition for investment.
Valentin Marinov, head of G10 FX strategy at Crédit Agricole CIB, suggests that a spike in UK headline inflation and FX volatility might force the Bank of England to consider outright FX market interventions to stabilize the currency. “We believe that the risks for GBP are still on the downside as we expect portfolio outflows and earnings repatriations from the UK to intensify from here,” he says.
But he also accepts that the sterling trade-weighted index is still above the level that might trigger official intervention. (To measure the overall change in the exchange value of a currency, a weighted average of the movements in cross-exchange rates against a basket of other currencies is used, with the weights reflecting the relative importance of the other currencies as measured by trade flows between the relevant countries.)
“The currency may have to fall significantly further (for example, another 10% against the dollar and euro) over a very short period of time to fuel concerns about financial stability,” adds Marinov.
When asked if the Bank of England might take direct action to prevent the pound falling below a specific level, Angus Armstrong, director of macroeconomics at the National Institute of Economic and Social Research (NIESR), observes that this is a fight the bank could not hope to win.
“The standard way of thinking about FX intervention is that you intervene when you can back it up with appropriate interest rate moves and the UK is in no position to do that because the economy simply isn’t strong enough,” he says.
Gregor Irwin, chief economist at advisory firm Global Counsel, agrees that the Bank of England will not intervene directly in the FX market to prop up the pound and says the Bank's Monetary Policy Committee (MPC) will be seriously considering loosening monetary policy over the coming months — a view supported by today’s MPC meeting. The Bank left rates unchanged at 0.5% at today’s meeting, but the minutes showed that most members think it will take action next month.
“That will place further downward pressure on sterling, although this has probably already been priced in by the markets,” Irwin says. “The Bank of England's view, for now, is likely to be that it is better to see through the impact that the fall in sterling has on inflation and instead to allow looser monetary policy to give the economy a boost.”
EU regulatory consultant Graham Bishop suggests that although the UK government has not publicly intervened in the FX markets, the uptick in end-of-day movement this week has raised the possibility that the government might have surreptitiously supported the currency.
“However, there has been no obvious attempt to arrest the major slide in the value of the pound and while we will know for sure when the monthly reserve figures are published, it is likely that the Bank of England would have acknowledged any direct intervention,” he adds.
In any case, trying to fight the market on this scale would be a case of “spitting in the wind”, Bishop adds, especially if the market realizes there is someone with deep pockets willing to take the other side.
As for how the eurozone will be affected by Brexit, he rejects any suggestion that the single currency has been damaged, referring to recent polls indicating an increase in support for the European Union in several member countries as evidence that the euro has been strengthened by the aftermath of the UK referendum.
However, Christian Odendahl, chief economist at the Centre for European Reform, describes Brexit as a negative event. “The eurozone is not in a position to easily manage economic and confidence shocks. Monetary policy is at the limits of what it feels it can do and fiscal policy is constrained by tight rules and high debt levels. The euro will survive as it is too costly to reverse it, but it will breed further political instability in the EU if it cannot be made an economic success.”
Armstrong at the NIESR notes that the volume of European financial services carried out through the UK means that if financial institutions were forced to change their business models and move some or all of their business elsewhere, intermediation efficiency would suffer. “This would lead to higher financing costs for European financial institutions,” he concludes.