“Examined through the most significant measures, it is clear that the current level of the pound sterling is not an obstacle to further significant declines” – RBC Capital.
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Despite falling to its lowest levels against the US dollar since 1985, the pound is still not cheap, suggesting further losses are likely, according to new research.
RBC Capital Markets says their measures of the “true” value of the pound suggests it remains near the top of a 30-year range and notes the bottom.
The exchange rate between the pound and the dollar (GBP/USD) fell to 1.1351 on Friday, its lowest level since 1985.
It is poignant that the drop comes on the 30th anniversary of Black Wednesday, when the pound abandoned the European exchange rate mechanism in 1992.
“In broad trade-weighted terms, the GBP is very close to where it was after this crash,” said Adam Cole, chief currency strategist at RBC Capital Markets.
As seen below, the GBP TWI puts the British Pound at the very bottom of its 30-year range.
Above: The trade-weighted value of the British pound, in blue, is based on the BoE’s GBP TWI).
“The fact that we are already at historic lows is a frequently encountered argument against further losses for the GBP from here,” says Cole.
But, Cole argues, it would be pointless to look at exchange rates in nominal terms over such long periods (i.e. one would have to adjust for inflation to get a better picture).
“There are many adjustments to relative inflation, but our favorite measure is based on relative labor costs,” says Cole. “On this basis, the GBP is not at the bottom of its 30-year range, but near the top.”
This is indicated by the black line in the table above.
Cole says this “real” measure reflects the rapid growth in labor costs in the UK relative to its trading partners, which he says owes the UK’s poor productivity performance.
In the decade before the pandemic, output per hour worked grew at less than half the average rate of the years before the 2008 global financial crisis. By the end of 2019, it was 20% below the level it would have reached if it had continued on its pre-crisis trajectory.
Above: UK productivity was hit hard by the financial crash of 2008. Image courtesy of FT.com.
“With the benefit of 30 years of decline, the pound was undervalued before its Black Wednesday crash, which had more to do with unsustainable domestic monetary policy than the exchange rate per se,” says Cole.
He says that at that time the UK current account was close to balance, compared to the 4% of GDP deficit seen in the last four quarters (or 8% of GDP in the first quarter alone), again suggesting an overvaluation relative to the time.
“Valuation alone is no reason to be bearish on the GBP and deviations from competitive fair value can be sustained for long periods without correction. But examined across the most significant measures, it is clear that the current GBP level is not a barrier to significant falls, based on the structural and cyclical factors we have identified,” Cole says.