When the late Paul Volcker took over the U.S. Federal Reserve in 1979, the American economy was suffering an uncommon malady known as ‘stagflation’ – a mix of high unemployment and inflation.
To defeat this, the Fed raised interest rates to as high as 21.5 per cent at one point. The measure instigated a massive recession that made the austere Volcker a boogeyman for many. Protesting farmers drove around the Fed building in tractors to vent their anger.
Despite the substantial economic cost, the ‘Volcker shock’ helped to curb price rises. But it had another significant side effect. Investors rushed to purchase U.S. government bonds, thereby causing the dollar to appreciate sharply, making exports uncompetitive.
The pound tumbled to $1.15 on Wednesday, its lowest level since 1985
By February 1985, sterling was trading at a record low $1.05, and the U.S. trade deficit had almost quintupled to $122billion between 1980 and 1985.
The dollar only began to devalue following agreements at a meeting of finance ministers at New York’s Plaza Hotel that September.
Volcker’s extraordinary actions were a watershed moment in American financial history. Monetary policy went from the control of politicians to the technocrats, and the financial system started its journey to becoming the behemoth it is today.
An even more kaleidoscopic-shaking situation is rocking today’s financial markets. The coronavirus has caused extreme economic as well as social harm in the last few months.
Paul Volcker (right) raised interest rates to as high as 21.5 per cent at one point after he took charge of the U.S. Federal Reserve to help defeat the USA’s high inflation levels at the time
What financiers are currently doing in response to Covid-19 is making the Volcker Shock look placid by comparison.
But the reaction of the currencies in both instances was quite similar. The pound tumbled to $1.15 last week, its lowest level since those heady days of 1985.
In many ways, this was expected. In times of crisis, people rush to the familiar and the safe. And for financiers that is usually not the pound, but the American dollar.
As Markets.com’s Neil Wilson wrote on Wednesday: ‘In a crisis like this King Dollar reigns supreme.’
U.S. Treasury markets are popular because of their greater relative depth and more robust liquidity. U.S. Treasuries are the deepest and most liquid assets in the world.
So remarks Ned Rumpeltin, European Head of Currency Strategy at T.D. Securities: ‘Given the circumstances, the U.K. looks like a rather risky proposition right now, so sterling has suffered accordingly.
Boris Johnson has so far refused to rule out extending the U.K. transition period despite the worrying threat of the coronavirus, making it more likely that Britain will leave without a deal, thereby depreciating the pound even more
‘Within this, we also think that this highly tense environment has made it difficult for international markets to gain access to U.S. funding for various dollar-denominated exposures. That has fueled this dash for cash that we think has resulted in GBP’s weakness.’
Even before the virus crisis, sterling lost some of its appeal as a reserve currency due to the uncertainty over Brexit.
The referendum in 2016 started a long period of political and economic uncertainty that has left investors nervous Britain will leave with weaker trading links with its largest trading partner.
Now that the coronavirus has relegated negotiations over the future UK-EU trading relationship to the background that uncertainty has been heightened again.
Viraj Patel, an FX and Global Macro Strategist at sotware firm Arkera, calls Brexit and Covid-19 the ‘two de-globalisation shocks’ to hit the pound in the last four years
Viraj Patel, FX and global macro strategist at Arkera, calls Brexit and Covid-19 the ‘two de-globalisation shocks’ to hit the pound in the last four years.
‘Equally,’ he adds, ‘bank balance sheet funds moving out of the U.K. banking sector in recent years – as a result of Brexit trade uncertainties – makes the pound slightly more vulnerable this time around.
Sterling has also had to contend with a much more long-term problem that is rarely talked about nowadays. For decades, Britain has run large trade deficits with the rest of the world.
Our economy relies heavily on foreign direct investment to keep the pound relatively stable, so when the taps run low, the pound’s value has to contract to make up for the lost capital.
Chancellor Rishi Sunak’s £330billion bailout package did little to stop the pound sliding. Many investors are asking him to go much further in arresting this decline
Could this not be good for exports? In theory yes, remarks ING’s Christopher Turner. However, he warns that spending is being hurt everywhere, ‘so the benefits might not be as large as expected.’
If private spending is down everywhere, then governments need to take the mantle and ‘do whatever it takes’ as so many are asking. However, the U.K.’s colossal stimulus measures have been relatively tame by comparison to other countries.
In a briefing note co-written by Ned Rumpeltin and other senior T.D. Securities executives, they stated: ‘Compared to other major countries in the region, it seems the F.X. market judged that the U.K. is behind the curve in terms of its contagion control efforts. Until that conclusion changes, we think sterling still faces downside risks.’
Chancellor Rishi Sunak needs to pull as many financial bunnies out of the hat as he can if he is to calm the markets. It is a tall order, but if £330billion did not do the trick, then hundreds of billions more may be necessary.
He really is going to have to do ‘whatever it takes’ if the pound is to avoid experiencing a major run.
Sterling was already up against it before this virus wreaked its havoc across the globe. Caution and half-measures will not stop that.
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