In today’s article, we will provide a recap of the history of the British Pound. According to the yearly BIS Foreign Exchange Turnover published in April 2016, the British pound is part of the G10 currencies and is the fourth most ‘traded’ currency with a daily average of 649 billion Dollars. Its percentage share of average daily turnover stands at 12.8%, and its two main ‘counterparties’ are the US Dollar ($470bn) and the Euro ($100bn).
Note that the exchange rate $/£ [or USD/GBP] is also called Cable, a term that derives from the advent of the telegraph in the mid-1800s. Transactions between the British pound and the US Dollar were executed via a Transatlantic Cable, and the first exchange rate was published in The Times on August 10th 1866.
This article will be split in two parts; the first one will [briefly] retrace the origin and the history of Sterling until the End of the Bretton Woods system in 1971, and the second part will explain the trends and reversals of Cable in addition to stating what I believe were the main drivers of the currency pair (from 1971 to today).
I. Origin and History of the Sterling pound between the mid-700s and the end of the Bretton Woods system (1971)
A. Quick history recap
Considered to be the oldest living currency in the world, the pound is 1,200 years old and was born in the latter half of the 8th Century, when silver pennies were the main currency in the Anglo-Saxon Kingdoms. The name [Sterling] pound (or Livre sterling in French) comes from the Latin word Libra Pondo, which means pound weight.
Back in the 8th century, 240 silver pennies represented one pound of weight and it was not until 1489 (under Henry VII) that appeared higher denominated coins with the first pound coin. Then, paper notes began to circulate after the establishment of the Bank of England in 1694, the world’s second oldest central bank (after the Sveriges Riksbank, the Swedish central bank). The Bank of England started as a ‘private company’ with the immediate purpose of raising funds for King William III’s war against France (issuing notes in return for deposits).
Even though there is an infinite amount of [inspiring] work on the Bank of England and the British currency, I am going to move directly to the 19th century when the British pound became the world’s reserve currency for a century after the Napoleon’s defeat at Waterloo in June 1815 (Foreign Exchange Reserves, Image 1). Great Britain arose as the leading exporter of manufactured goods and services and the largest importer of food and industrial raw materials. Between the mid-1800s and the outbreak of WWI in 1914, 60 percent of the global trade was invoices and settled in British pound (B. Eichengreen, 2005). London became the world’s financial capital in the late 19th century and the export of capital was a major based for the British economy until 1914. As foreign governments were seeking to borrow in sterling, British financial institutions established branches in the colonies and colonial banks opened offices in London. In 1913, Sterling’s share in the Official Foreign Exchange Assets stood at 48%, above Francs (31%) and Marks (15%) according to Lindert’s calculation (1969).
B. WWI outbreak and its consequence on the UK (and Sterling)
Although the US economy surpassed the British economy in size [in real terms] in 1872 (Gheary-Kamis, 1990), the important switch occurred in the early 1910s:
- the US became an net creditor while the became a net debtor
- and more importantly, the Federal Reserve was established in 1913 (December 23rd), with the enactment of the Federal Reserve Act
At the outbreak of WWI, the gold standard was suspended and restrictions were placed on the export of gold, which obviously had a negative impact on the British pound (vis-à-vis the US Dollar) as we can see it on Chart 2a. Prior to and during most of the 19th century, one pound was roughly worth 5 US Dollar (Chart 2b), with some ‘turbulence’ in 1860s due to the American Civil War.
Severe inflation (20%+), lack of demand, a high unemployment rate (above 10%) in addition to a 25-percent drop in economic output between 1918 and 1921 launched the Great Depression in United Kingdom at the end of WWI, which last for two decades. The pound first plummeted from $4.70 to $3.50 during that 3-year period before swinging back to its prewar levels (at $4.87).
C. ‘In between’ the Two Wars
The pound ‘rebound’ in the early 1920s (Chart 2a) could be explained by the political desire to maintain the value of Sterling at a ‘high’ rate (i.e. prewar levels) to give Britain an [economic] successful image to the rest of the World. In order achieve that, the UK had to run contractionary fiscal and monetary policy (Image 2a), which increased interest rate differentials (i.e. attracted savings in Britain) and pushed the UK inflation rate below the US one. As the US inflation rate was already very low at that time, the UK was experiencing deflation at that time (Image 2b).
Then, in 1925, Britain re-adopted a form of Gold Standard where the exchange rate was determined by the relative values of gold in the two countries, with a fixing at 4.86 US Dollar per unit of Pound. This Gold Standard ‘return’ was considered to be disastrous (Churchill’s biggest mistake as he was serving as the Chancellor of the Exchequer at that time), as it resulted in persistent deflation, high unemployment rate that led to the General Miners’ Strike of 1926. The UK was stuck in the debt vicious spiral; running a contractionary fiscal and monetary policy during a deflationary recession was increasing both the amount of UK debt in real terms and its burden (high interest rate increased the cost of borrowing). This led to a Balance of Payments issue, and led to a run on the pound. On the top of that, the Wall Street Crash and the beginning of the Great Depression put the British economy under intense pressure, which eventually came off the Gold Standard in September of 1931. In the year that followed, the British pound dropped to lower lows to around 3.25 against the US Dollar. However, as Barry Eichengreen noted in his paper Fetters of Gold and Paper, countries that came off the Gold Standard early (i.e. UK) did better [or less worse] than the countries that remained on it for longer (i.e. US). After a 3-year [1930-1932] pronounced deflationary period in the US (Image 3), rapidly rising prices in the summer of 1933 (after the US went eventually off the gold standard on June 5th 1933) eased the ‘strain’ on other countries and kicked off the dollar depreciation. The British pound rapidly recovered its losses and surged to a new high of $5 by 1934 (Chart 2a). The pound remained afloat and oscillated at around $5 until 1939 and the outbreak of WWII. This depreciation (which brought back the British pound to its low of 3.25 against the greenback) was mainly due to uncertainty around the outcome of the war, as fundamentals were expected to deteriorate very quickly (output collapse, a rise in inflation) indebting the British economy even more.
D. World War II and Bretton Woods period
In 1940, an agreement between the US and UK pegged the pound to the greenback at a rate of $4.03 per unit of pound. This exchange rate remained fixed during WWII and was maintained at the start of the Bretton Woods system (Chart 2a). British emerged from WWII with an unprecedented debt of nearly 250 percent as a share of GDP (most of it owned to the US) with ‘strong’ currency, a [much] less dominant market in terms of competitiveness and a degrading balance of payments (Hirsch, 1965). Despite the soft-loan agreement (a 3.75 billion-dollar loan to the UK by the US negotiated by JM Keynes at a low 2% interest rate with repayment over fifty years) to support British overseas expenditure post WWII, the British pound remained under intense pressure. Chancellor of the Exchequer Sir Stafford Cripps eventually announced a 30-percent pound devaluation from $4.03 to $2.80 in September 1949.
However, the devaluation was not enough as the following two decades were characterised by persistent balance of payment problems and led to the Sterling crisis of 1964-1967. The UK was forced to seek assistance from the Bank of International Settlement and the IMF more than once. Despite persistent current account deficits and a deteriorating balance of payments in 1964-1965 (Image 4), UK officials didn’t react (i.e. devalue) as they argued that devaluation would severely strain Britain’s relations with other countries when the main holders of sterling would begin to withdraw their balances from London and also threaten the international monetary system (Bordo & al., 2009). The pound weakness persisted in 1966 and 1967, covered by lines of credit received by other central banks (i.e. swaps with the NY Fed) and the IMF. But the government eventually ceded and PM Harold Wilson announced that the pound would be devalued from $2.80 to $2.40 on Saturday 18 November 1967. It then remained at that level until end of Bretton Woods.
II. The trends and reversals of Cable since the End of the Bretton Wood System in 1971
Note that all the periods and important events are marked in Chart 1 (see end of article).
A. The Nixon 1971 Shock and Smithsonian Agreements (1971 – 1973)
In addition to signing the Smithsonian agreement at the December 1971 G10 meeting, where the US pledged to peg the dollar at $38 an ounce (instead of $35 during BW) with 2.25% trading bands (instead of 1 percent), the UK also agreed to appreciate their currency against the US Dollar. The pound was worth $2.65 by the end of the first quarter 1972.
B. 1973 – 1976: a rough start
However, it did not take too long for troubles to ‘come back’ in the UK and the pound experienced a series of speculative attacks in the mid-1970s. Cable hit a low of $1.5875 in the last quarter of 1976 and the UK had to call the IMF to counter persistent runs on Sterling. This loan was followed by a series of austerity measures, which helped reduce inflation and improve the economic activity, hence boosting the pound in the second half of the 1970s.
C. 1976 – 1980: US inflation and the Dollar depreciation
The positive UK-US carry trade due to low interest rate run by the Fed in the mid-1970s (as a response to the post first-oil shock recession) gave birth to a four-year shining period for Cable, which recovered by 54% to hit a high of $2.45 in the last quarter of 1980.
D. The V shape of the 1980s
I like to describe the 1980s as a V-shape curve for Cable as there were two major trends during that period. As a result of the second oil shock caused by the Shah revolution in Iran in 1979, oil prices doubled in the following year leading to a sharp increase in inflation in the US in 1979-1980 (peaked at 15% in the first quarter of 1980). In order to reign in the double-digit inflation, Fed chairman Volcker reacted immediately by orchestrating a series of interest rate hikes that levitated the Fed Funds target rate from 10% to nearly 20%. Even though the dramatic increase in interest rates caused a painful recession and a surge in unemployment rate (11%) in the US, it eventually led to international capital inflows as high [real] interest rates became attractive to foreign investment. What followed was a severe appreciation of the US dollar vis-à-vis the major currencies; Cable lost more than half of its value and hit a historical low of $1.0520 in the first quarter of 1985 (Chart 1). This Dollar Rise under the Reagan administration was a problem for the US economy as the current account fell into substantial and persistent deficit (Image 5a). In addition, the US was also running large budget deficit of 5%+ during the same period (Image 5b), which put the country in a twin deficits anomaly and caused considerable difficulties for the American industry (i.e. car producers, engineering and tech companies…).
Therefore, in order to re-boost the US economy, the Plaza Agreement was signed in New York on September 22nd 1985 and France, Japan, West Germany and the United Kingdom agreed to depreciate the US Dollar by intervening in the currency markets. This decision created a secular change in the financial market and immediately reversed the 5-year bull momentum on the US Dollar. The Pound reacted and appreciated roughly 80 percent in the following three years. I am not sure if the [financial] sentence ‘Don’t fight the central banks’ came from this decade, but I think it is a good example to show you how much effect a central bank cohort move can have on the market.
E. 1988 – 1992: the volatile period
We saw a consolidation between 1988 and 1989 to $1.51 after Margaret Thatcher’s Chancellor of the Exchequer Lord Lawson decided to unofficially peg the British pound to the German Mark (UK wasn’t in the Exchange Rate Mechanism yet (Image 8, green period). This caused inflation, a credit bubble and a property boom that eventually crashed in 1989-1990 followed by a recession.
Cable started to recover in the first quarter of 1990 as the interest rate differential increased preference for the British pound (Chart 3). In the middle of 1989, the Federal Reserve began to run a loose monetary policy in order to boost the US economy weakened by the Savings and Loan crisis of the 1980s and 1990s. Fed’s chair Alan Greenspan decreased the Fed Funds rate from 9.75% in March 1989 to 3% in September 1992 to boost productivity (Chart 3). Cable double topped at [perfect] resistance $2.00, a first time in Q1 1991 and a second time in Q3 1992.
It is also important to note that during that time, the Conservative government (Third Thatcher ministry) decided to join the Exchange Rate Mechanism on October 8th 1990 (Image 8, grey period), with the pound set at DM2.95.
16 September 1992: Black Wednesday and ERM exit (Source: Inside the House of Money)
Also called [another] Sterling crisis, the British government was forced to withdraw the Pound Sterling from the ERM on that day, sending the pound into a free fall. Cable tumbled by 30% from [Q3 92] peak to [Q1 93] trough. But what really happened then?
As we mentioned before, the UK tardily joined the ERM in 1990 at a central parity rate of DM2.95 and a trading range band of +/- 6 percent. The exchange rate was arguable judge too strong by many economists at that time, therefore the overvalued currency in addition to high interest rates and falling house prices led the country into a recession in 1991. It became difficult for UK officials to maintain the value of the Pound at around its target against the Deutsch Mark. Meanwhile, Germany was suffering inflationary effects from the 1989-1990 Unification, which led to high interest rates. Therefore, despite a recession, the UK was ‘forced’ to keep interest rates high (10% in September) to maintain the currency regime. Speculation began and global macro traders (i.e. Soros) increasingly sold pounds against the Deutsche Mark. To discourage speculation, UK Chancellor Lamont increased rates to 12% on September 16th with a promise to raise them again to 15%. However, traders continued to sell British pounds, as they knew that increasing rates to defend a currency during a recession is an unsustainable policy.
Eventually, on 16 September 1992, the UK government announced that it would no longer defend the trading band and withdrew the pound of the ERM system. The pound lost 15 percent of its value against the DM in the following weeks and traded as low as DM2.16 in 1995.
Even though we usually do our analysis of a specific currency vis-à-vis the US Dollar, I thought it was important to mention the presence of the Deutsch Mark as it explained Cable’s depreciation in 1992 and 1993.
F. 1993 – 1998: the Dull period with shy Sterling Gains
After the ERM exit, it was dull period for the USD/GBP, Cable oscillated around $1.60 with a shy little upward trend (i.e. shy GBP gains) helped by the small interest rate differentials and a series of trade balance surpluses. It looks like the $1.70 psychological resistance was hard to break between 1996 and 1998 and the Pound traded within a ‘tight’ 10-figure range during these years.
One important event during that period was that the Monetary Policy Committee was given operational responsibility for setting interest rates in 1997 with one [only] mandate: maintain a 2-percent inflation rate in the long run. Traditionally, the Treasury set interest rates.
G. 1999 – 2002: The Sterling Depreciation
As we saw for the Euro (and the Yen at a lesser extent), the turn of the century was marked by a Dollar appreciation between 1999 and 2002. Cable lost a bit of steam during that period and spent a lot of time flirting with the $1.40 support in 2000 and 2001 (it even hit a low of $1.37 in Q2 2001). I have not found any supportive literature to explain this downward bias, but it is not absurd to assume that some of the dollar strength came from a surge in the equity market capitalization in the US – with the Tech Boom – and potentially a higher productivity than in the United Kingdom.
H. The 2002 – 2008 GBP appreciation (or US Dollar depreciation)
The US Dollar started to tumble in late 2001 / early 2002, which was the beginning of a 6-year bull period for Cable. The exchange rate went north 50% and reached a high of $2.11 in the last quarter of 2007 (with a small consolidation in 2005). The (inflation-adjusted) trade-weighted dollar exchange rate (i.e. see REER) steadily depreciated, falling by roughly 25 percent (Image 6). During that period, US was printing persistent twin deficits: Current Account deficits print a high of 6 percent in 2006 (Image 7a) while Budget deficits were ranging between 2 and 3.5 percent as a share of GDP (Image 7b). In addition, the Fed decreased interest rates to 1.75% after the 9/11 attacks and then to 1 percent in 2003, helping the government to roll its debt at lower costs and finance the Iraq War (total cost to the United States was at 3 trillion USD according to Stiglitz and Bilmes, 2010).
I. 2008: Financial Crisis and the Risk-Off aversion
The British pound saw a massive depreciation in 2008 due to the risk-off sentiment and the sudden demand for Dollars; Cable tumbled 36%+ from [Q4 2007] peak of $2.11 to [Q1 2009] trough of $1.35. In the early 21th century, Sterling had lost its reserve currency for a long time, so when asset prices took a massive hit in 2007-2008 the pound did too. The two currencies that acted as ‘strong’ safe-havens were the US Dollar and the Japanese Yen. This raised an interesting debate on whether countries should have huge amount of debt (denominated in their local currency) in order to have a currency that acts as a safe-haven in harsh period. When you think about it, the two safe-havens are the currencies of the two most indebted nations ($20tr for the US and $11tr for Japan, as of today).
The UK was sharply impacted by the crisis; to give you an idea, the pound’s [36-percent] fall vis-à-vis the US Dollar wasn’t even enough to make up for weakening foreign demand. It took the country’s economy 6 years to come back to its pre-crisis level (summer 2014, ONS), with a debt-to-GDP ratio that soared from 51% in 2008 to 89% in 2014.
Bank of England’s answer: Like many other central banks, the BoE slashed rates from 5 percent in the beginning of 2008 to 0.5% in Q1 2009 (the lowest since the BoE establishment in 1694). In addition, the Bank of England press the QE bottom like in the US and created £375bn of new money between 2009 and 2012.
The series of measures adopted by central bankers brought back interest in the Sterling pound, considered to be ‘cheap’ or undervalued relative to its peers. Cable regained 50% of its value in three quarters and hit a high of $1.71 during the third quarter of 2009; however, the recovery wasn’t very long as the Sovereign debt crisis emerged in Europe (at that time is was Greece) and impacted the British economy (and its currency) as well.
J. 2011 – summer 2013: the other dull period
Bizarrely, the British pound wasn’t affected too much during the [second] EZ sovereign debt crisis between Q3 2011 and mid-2012. For almost two-and-a-half years, Cable traded around $1.50-$1.60 with pressure on the downside in the beginning of 2013. The pressure came after it lost its top AAA credit rating for the first time since 1978 on expectations that growth would ‘remain sluggish over the next few years’. At that time, traders were starting to predict that Cable would retest its 1.40-1.4250 support range as the Pound was clearly not a hot currency in the beginning of 2013. In addition, investors were also starting to look at the Euro’s momentum after the buy-on-dips that followed Draghi’s ‘Whatever it takes’ in July 2012.
Despite the UK weakness, the British pound didn’t fall to further levels as it was ‘saved’ by a dovish Fed and a US Dollar in the coma. In the last quarter of 2012, Bernanke announced a further round of QE with monthly purchases totalling $85bn (of Treasuries and MBS) in order to boost productivity. This prevented the British pound of depreciating too much and raise interest in the cheap Euro at that time.
K. August 2013: New BoE Governor Mark Carney took office and the Pound experienced a fantastic year
In the summer of 2013, Marc Carney left the Bank of Canada to take over Mervyn King’s place as the new Governor of the Bank of England. Then, what followed was a series of good news and positive fundamentals in the UK; the British pound switched from the no-interest status to traders’ favourite currency (with the Euro, there were the market’s Darlings). Cable soared from its $1.48 lows to hit a 6-year high of $1.72 with market participants pricing in a sooner interest rate hike. Cable’s good driver of that one-year bull period was the increase in implied rates [looking at the short-sterling futures contract]. Moreover, Britain was the fastest-growing major economy in 2014, printing an annual growth of 2.9% (surpassing the US and its 2.4%).
L. Summer 2014: the Dollar wake-up and the start of a Bear currency market for the Pound
As I already wrote it in a previous post on the UK, the last positive words on the British economy came out of Carney’s mouth during a speech he gave at the Mansion House on June 12th 2014 (the same night of the kick-start of the World Cup in Brazil). He said that the UK was on a positive momentum (i.e. fundamentals were good) and hinted that the Bank of England may rise rates sooner than the market expected. At that time, I remember that the futures market was pricing in a 25bps hike by the end of Q4 2014.
However, everything vanished a few weeks later and more and more participants were starting to notice that the British pound was showing signs of ‘fatigue’ and that a consolidation was coming. In addition, May 2014 was also the announcement of the ‘Euro’s Death’ and that the single currency expected depreciation may spur an overall Dollar strength. And it happened… According to the DXY index, the Dollar strengthen by 25 percent against its main trading partners between July 2014 and March 2015. Cable tumbled from a $1.72 to $1.4635 during that same period.
In early 2015, most of the market participants was pricing in another 15 to 20 percent increase in the Dollar on expectations of the Fed starting a tightening cycle (taking the two previous Dollar Rally that we described earlier as empirical data: the Reagan Rally in the beginning of the 1980s and the Clinton Rally that occurred in the late 1990s).
2016: The Brexit effect and monetary policy divergence
After a brief pause in 2015 as the Fed halted its tightening cycle [due to the sharp sell-off that occurred in the beginning of 2016], Cable continued its bear market against the US Dollar in 2016 on speculation of a Brexit Yes vote first (in favour of leaving the EU), and then on the concretisation of the Yes vote (52% in favour of Brexit) following the referendum held on June 23rd. The pound traded below the 1.20 level against the greenback after the announcement, its lowest level in 21 years, and remains currently under pressure as Brexit uncertainty will continue until Article 50 gets triggered.
BoE answers to Brexit
After four years of status quo [and hints of potential rate hikes], the Bank of England announced a new round of QE in August last year targeting £60bn of monthly purchases (of which £10bn of corporate debt) and cut its Official Bank rate by 25bps to 0.25%. With the Fed now [seriously] reconsidering starting a tightening cycle after a first hike last month and three potential rate increase in 2017 (DotPlot Gradual Path), the monetary policy divergence between the US and UK and the political uncertainty in Europe (and UK) will weigh on the pound in the near future.
Chart 1. GBPUSD historical monthly candlesticks since 1971 (Source: Bloomberg)
Chart 2a. Cable historical rate 1915 – 2013
Chart 2b. Cable historical rate since 1791
Chart 3. UK Official Bank Rate (Red Line) versus US Fed Funds Rate (White Line)
Image 1. Reserve currency status (Source: JP Morgan)
Image 2a. UK Budget deficit in the 1920s (Source: ONS)
Image 2b. UK Inflation Rate in the 1920s (Source: ONS)
Image 2c. UK Unemployment Rate in the 1920s (Source: ONS)
Image 3. US Annual Inflation in 1930-1939 (Source: BLS)
Image 4. UK Current Account in the 1960s (Source: Trading Economics)
Image 5a. US Current Account in the 1980s (Source: Trading Economics)
Image 5b. US Budget Deficits in the 1980s (Source: Trading Economics)
Image 6. US Dollar REER (Source: OECD)
Image 7a. US Current Account in the 2000s (Source: Trading Economics)
Image 7b. US Budget Deficits in the 2000s (Source: Trading Economics)