The British currency has been under pressure before and it didn’t end well


The pound is under pressure. A foreign central bank is fighting inflation and has raised interest rates, which has inflated its currency. Sterling, along with others, loses.

On September 16, 1992, these tensions – and others – combined with speculative trading to create Black Wednesday, when the UK collapsed from the Exchange Rate Mechanism (ERM), a system linking several European currencies.

The Bank of England had intervened, spending billions to try to support the pound and keep it within a defined range, but to no avail. Doubts about the ability of the authorities to correct the situation had prompted the market to go on the attack.

“There was a tense atmosphere inside the bank,” said Stuart Cole, who joined the BoE a few months before Black Wednesday and is now chief macroeconomist at Equiti Capital.

“It was the bank against the markets. There was a feeling of foreboding where you knew it was going to end badly.

Fast forward 30 years and a lot has changed in politics, markets and currency trading, and most importantly, the pound is no longer pegged. But the pound sterling finds itself under pressure again thanks to the actions of a central bank.

This time, instead of the German Bundesbank and the Deutsche Mark, it’s the US Federal Reserve and the dollar.

As the Fed hikes rates to control inflation, the US currency is on a bull run. The pound is down about 15% this year, heading for what would be only its fourth double-digit full-year decline against the greenback since 1992.

The current weakness has sparked rumors – far-fetched, some say – that the pound looks like an emerging market asset and that a widespread currency crisis is possible. The argument is that investors might be scared off by the tax cuts and increased spending promised by new Prime Minister Liz Truss.

Norman Lamont, Britain’s Chancellor of the Exchequer at the time of Black Wednesday, says there’s not really a connection between that event and today, and that the negativity is exaggerated.

“I don’t think the pound can be compared to an emerging market currency,” he said. “Britain is still an attractive destination for foreign investment.”

But Ms. Truss inherited an economic whirlwind. Inflation is near a 40-year high and consumer confidence has plunged, although the government’s ambitious plan to cap energy bills eases near-term pressures.

Recession warnings weighed heavily on the pound, thwarting the impetus of six consecutive rate hikes by the BoE and another, potentially the largest yet, expected next week.

The current account deficit, which is the gap between money coming into the UK and money going out, is also alarming after widening to a record 8.3% in the first quarter.

With such a litany of pressures, the government cannot afford to be complacent in the face of investor pessimism, according to Harriett Baldwin, who was in the currency desk at JP Morgan during Black Wednesday and is now a Conservative Party MP.

“I was there during the bond market crash of 1994,” Ms Baldwin said, referring to the sell-off that year triggered by rising interest rates in the United States. “When they go, they can go faster than you think. We have to be careful.

The UK’s exit in 1992 was a political humiliation for the government. For many currency speculators, this was a huge investment gain.

By late afternoon on September 16, the BoE was no longer trying to stop the currency rout. George Soros made an estimated profit of $1 billion and became known as “the man who broke the Bank of England“.

Britain was not the only loser at the time: Italy temporarily left the ERM and the Spanish peseta was devalued.

“It was chaos,” said Neal Kimberley, who at the time was a senior trader at Bank of Nova Scotia in London. “I think some people hit their annual goal between five and five-thirty.”

Since then, the economic fallout on the UK has been somewhat reassessed. The devaluation helped the economy, inflation was brought under control, and the policy response got the ball rolling by giving the Bank of England monetary policy independence.

“The period of joining the ERM was not a very dignified episode. A somewhat cruel summary would be to say that we entered the ERM out of desperation and came out of it in disgrace. Nevertheless, we still profit from it,” said Alan Budd, a founding member of the BoE’s monetary policy committee in a 2004 speech.

For the BoE, the post-ERM policy restructuring led to the introduction of inflation targeting. While that remains the framework to this day, it seemed challenged this summer when Prime Minister Liz Truss said the central bank’s mandate needed review and potentially a new focus.

Charlie Bean, a former central bank deputy governor, said late last month that such actions could pose a risk to UK assets.

Ms Truss’ choice of chancellor, Kwasi Kwarteng, has since backed the current term and said the independence of the BoE was sacrosanct.

tax cuts

While the UK’s economic outlook is undeniably painful, strategists and traders agree that the pound’s weakness is primarily a story of dollar strength. The euro has also fared poorly, while the yen has crashed almost 20% against the greenback this year.

But the UK’s domestic policies are also being closely watched.

Mr Kwarteng will deliver a budget statement next week, when he is expected to give more details of Ms Truss’ tax cuts and the government’s support package to help people with rising energy bills.

Investors will be waiting to see how it will all be funded.

Updated: September 16, 2022, 08:14

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