Attempting to quantify the impact of sterling weakness

Another day, another trip to the hospital for Betty as sterling sold off sharply yet again.  While the so-called Flash Crash has certainly projected the pound into the public consciousness, ironically enough it trades as if medium term discretionary punters (if such a creature even exists any more) aren't really very short at all.   CTAs and models, sure: just look at the CFTC data.  But day to day price action certainly trades as if macro/FX guys are hoping for a decent rally to sell...and not getting it.

(Parenthetically, any global financial regulator disturbed by last week's sterling crash should take a good look in the mirror and consider the irony of karmic justice.  In the "bad old days" when bank spot and prop desks took risk on a principal basis, sudden dips resulting from a liquidity air pocket were swiftly bought by those traders, certainly well before anything like an 8 or 9 big figure sell-off.  By forcing banks to more or less act solely on an agency basis, regulators have put the market at the mercy of black box 'liquidity providers' which can also act as seek and destroy robots.   This type of price action is more or less inevitable in a large enough sample size; for better or for worse, regulators have gotten the market that they wanted.)

In any event, Macro Man has some sympathy for the view that sterling is cheap on a long term structural basis, though of course that says little about where it is going in the next day, week, or month.   For what it's worth, the OECD puts cable PPP at 1.44 these days and EUR/GBP at 0.90.   (That latter figure seems awfully high, as does the EUR PPP of 1.30.  Macro Man would peg the latter closer to 1.20, and EUR/GBP closer to 0.80.)

One subject that is becoming a frequent topic of discussion is the degree to which sterling's free fall will benefit the economy.   If maintained, of course it will help boost exports, though how much will naturally depend on the tariff umbrella under which the UK eventually trades.  (The boost to exports should come earlier, of course.)   Initially there could actually be a deterioration in the trade account via the well-known J curve effect, in which import prices go up but volumes remain steady.  Eventually, we can naturally expect imports to decline, improving the balance of trade...though potentially with a hit to household spending if volumes adjust downward in response to price.

Ordinarily, households would be cushioned by a more aggressive easing of monetary policy in response to an economic shock.  That's not really an option here, so it seems reasonable to expect less of a beneficent impact from a weaker sterling than has historically been the case.   One way that we can attempt to quantify this is via a monetary conditions index, which equates moves in the trade weighted exchange rate with changes in interest rates.    A useful rough and ready estimate is that a five percent move in the exchange rate is equivalent to a one percent change in interest rates.  (Note that the ECB MCI uses a 6-1 ratio.)  The chart below shows monetary conditions in the UK relative to the average between 1998 and 2007, which represented a full monetary policy cycle from an independent Bank of England.

As you can see, the downdraft in the sterling TWI has had a notable easing impact, though much less than observed in the early 90's after the ERM crisis or during the GFC.  As such, it's hard to see it being a panacea for any potential potholes that may emerge.   A potentially valid criticism of this model is that the UK is a pretty open economy, and as such should tilt its MCI weightings more heavily towards the exchange rate.  

UK trade as a percentage of GDP is comparable to that of Canada, another open economy perched on the doorstep of an economic behemoth, with whom it has a free trade agreement.  (For the time being at least in the case of the UK!)   The BOC managed policy to an MCI index for a while in the 1990's before junking it in favour of inflation targeting.   Their MCI was weighted 3 to 1, which may arguably be a more  apt fit for the UK.   The chart below illustrates a UK MCI with those weights:

As you can see, the current move still pales in comparison with prior sharp easings; both the early 90's and the GFC period saw conditions ease by 15% on this index basis.  Looking at this index in a little more granularity, we can see that as of yesterday the sterling MCI had done about half of that.

Of course, the starting points are not identical.   The early 90's saw a recession, property crash, and ERM currency crisis.   2008-09 was of course the financial crisis and concomitant bone-jarring recession.   What we have now is a constitution altering vote of uncertain ultimate consequences that has left roughly half the country happy, half the country sad, but everyone, judging by the tone of the discourse, very angry indeed.  We do not, on the other hand, have recession as a starting point.


It's perhaps best left to the econometricians to make hard and fast forecasts of the impact of the MCI move.  From Macro Man's perch, he can see a clear upward impulse to inflation via the import channel.  As for growth, to date it hasn't collapsed so there isn't much of an argument for a sharp upswing in response to the sterling weakness.  As noted above, next exports will certainly improve, though potentially at a cost to consumption data, leaving the boost to GDP growth somewhat muted.

Eventually, conditions should evolve such that there is a case for sterling appreciation.  It is far from clear that the level is here and the time is now, though obviously longer term investors may have the luxury of starting to peruse the family jewels goods on offer.  From a purely selfish perspective Macro Man would love to see cable back to it's 1980's lows...having endured years of cable at 2.00, he'd love to be able to walk around London marveling at how cheap everything is for once.