For most people in Britain, last week’s “flash-crash” in the pound, coming out of the Asian markets in the early hours of Friday, was merely a mild curiosity.
It was like a flash of lightning in the night from a faraway storm. Interesting, but no big deal.
But the pound is a warning signal, a canary in the coal mine. It is trying to tell us that bad things are coming.
Usually, when a currency slips, it is notable if the movement is greater than 0.5%. A currency, after all, represents a country’s economy as a whole. It is difficult to move such a broad-based asset in a single day. If a currency were to slip more than 1%, then you would assume some surprisingly bad news has occurred.
Sterling is now down 14%.
“Since the day of the referendum, we have seen a 14% decline in the sterling effective exchange rate, out of which around 3% occurred this week itself,” Credit Suisse analyst Sonali Punhani wrote in a note to clients recently.
The dumb way to look at this is the way is presented in most news media: Our foreign holidays will get more expensive! But our exports will get a boost because they are now cheaper for other countries to buy!
Do not be fooled. This is temporary. It is the calm before the storm. Winter is coming.
We know the exports boost is only temporary because Brexit has not happened yet. The pound is cheaper but we still have 100% access to the EU. When the UK leaves that will change, and not in our favour.
In a “hard Brexit,” Britain will be trying to trade from outside the Single Market. The EU countries are likely to apply barriers and tariffs to make our stuff more expensive and to give their own stuff an advantage. The cost of that could be a 15% tax on every British export product. At the same time, we are trying to compete with a currency that is getting weaker. There is no way to win that battle.
A weaker pound creates inflation. The price of everything we need to import is going up. That is going to make British workers poorer, and reduce their consumer spending, which has an overall dampening effect on GDP. Here is Credit Suisse’s inflation forecast for varying levels of “the cable” (the nickname for the dollar/pound exchange rate.
A weaker pound means people get less for their investment. Capital is likely to flee the UK. You can see the effect of that in this chart from Sky News and Bloomberg, which shows the FTSE 100. If you measure it in pounds, it looks great. But if you invested in dollars, you lost money over the period due to the weakened pound:
Put those things together: We are blocked from the Single Market, so we cannot trade. Our currency is weaker, so our buying power is reduced. We will have inflation, so our consumer spending will decline. And we will get lower investment, because who wants to put money into a currency that is worth less?
Bank of America Merrill Lynch analysts Gilles Moec and Robert Wood say the UK could lose 2.5% of its GDP:
“We remain pessimistic about the outlook beyond the very near-term. Sterling’s fall will hurt real incomes and uncertainty will weigh on investment, in our opinion. … we think risks to future trade terms have worsened. We still assume the UK and EU agree to a free trade deal, which could involve higher non-tariff trade barriers and could be termed a ‘hard Brexit’.”
“Our base case could be called a ‘hard Brexit’, which we assume reduces GDP by 2.5% in time. But recent comments from the government raise the risk of a more damaging outcome (WTO rules). In sum, we believe the past week probably provides a window into the volatile economic environment Britain could face in the coming years. Such a situation would not be conducive to growth.”
That is a recipe for a recession. And it is far from clear that the folks who voted to Leave realise that this is the natural consequence of their actions.
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