Foreign exchange: what’s happened to the pound?

The foreign exchange market has been fractious of late, and the weak pound is putting more cost pressures on businesses.

How would you characterise recent events in the FX markets, and specifically, what’s really happening with the pound?

“I’d say the past eight to 10 weeks have been fractious, as far as the foreign exchange market is concerned. There’s been a general loss of risk appetite from investors, but also a more difficult period as far as liquidity is concerned. For the pound, this was exacerbated by political and economic factors. Sterling’s fall to near $1.03 was undoubtedly the fallout from Liz Truss’s mini budget in September, but it happened out of European and US trading hours and was mostly due to Asian markets, where liquidity was very light, meaning a more extreme sell-off. Sterling recovered, but to me this was a short-term bounce – rather than people wanting to buy sterling, I think they were lightening their trading positions where they’d sold sterling short.

“I don’t think there is a significant improvement in confidence around the UK economy, the UK fiscal position, the UK monetary policy position, or indeed in terms of risk appetite generally.”

How long can we expect this situation to last?

“How long is a piece of string? We probably won’t get back to a more normal set of circumstances until we can be more confident about identifying the bottom of the UK economic performance. This will be data driven, but probably in three to six months we’ll say with any degree of certainty that sterling has hit its base against the US dollar.

“It’s trickier when you look at sterling against the euro because neither economic area is performing particularly well. So it’s more a question of which markets expect to perform worse, their assessment about interest rate differentials and which currency they’re least attracted to hold.

“I think that the UK’s economic position will worsen relative to Europe. We could see sterling drop back against the euro as we head through the next three to six months.”

What does a weaker pound mean for inflation and the cost pressures businesses are facing?

“The weak pound adds to those pressures. Even if we’re talking about a few percentage points, it just adds to the cost pressures businesses face, such as raw material prices, energy prices, and things like shipping.

“But I do think that while we have a little bit of a weaker pound, there will be an additional correction in commodities prices, shipping costs and so on, driven by the global economic environment. The UK might not benefit as much as it could, but it will still benefit from cost reductions versus where we were some months ago.

“A weaker pound could mean we take longer to trend back towards the 2% inflation target, maybe a quarter or so. But by the second half of 2023, you might see the pound turning around against the US dollar. And so what we’re talking about now, in terms of some additional cost pressures, might then fade. And the UK might perform relatively better than the US and Europe.”

Do you see many benefits for businesses?

“One issue is whether or not corporate valuations look attractive to investors relative to counterparts in Europe or other parts of the globe. We could see an influx of inward investment and foreign capital into the UK, driven by the weakness of sterling that we’ve seen recently.”

How can businesses protect themselves against uncertainty and fluctuations?

“Businesses have to be much more focused on when payments need to be made, how they need to be made, and what the underlying exposure is. If you’re buying from China, you’re not really buying in dollars because there’s a conversion going on between dollar and the renminbi. So what’s happening in the renminbi? And if there’s a stronger understanding of that, then that might give businesses greater power when they’re negotiating with suppliers.

“Businesses should also make sure they’re accurately forecasting the trends within their own sector so that they don’t overstock. I suspect UK businesses will hold less stock because they’re expecting less demand, but how quickly can they react if things do then pick up? Also, can they look at diversifying supplier bases, thereby giving them greater protection against exposure to one specific currency?

“From a foreign exchange market, businesses need to consider how they hedge against currency movements and what instruments they use, with an eye to the whole picture. If they use a layered approach, they might not hit the highs, but they’re also not going to hit the lows, so you’re going to have a much steadier picture as far as your currency edging profile is concerned over time.”

How can businesses best scan the horizon, and what sources of information should they look at?

“It’s very hard for any central bank, or indeed any forecasting organisation, to forecast in the current environment. For instance, very few people saw the weaponisation of energy by Russia after its invasion of Ukraine. That event has blown every forecast out of the water this year.

“Businesses will still want to use forecasts, and the key is understanding how they work. The Bank of England’s Monetary Policy Committee (MPC), for instance, will forecast using fan charts: a projection of the likely highs and lows and what they think is going to happen. So rather than looking at just what the most likely outcome is, businesses might find it worthwhile doing some scenario analysis, asking what would happen if we hit a high and what would happen if we hit a low.

“Businesses should use a variety of sources to provide a better indication of what’s potentially going to happen as far as the global macro picture is concerned. What does the International Monetary Fund say, as well as the Organisation for Economic Cooperation and Development, the World Bank, and resources such as Reuters’ poll for foreign exchange market forecasts? The range of those forecasts might be very wide but it will give businesses a better picture.”

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