The economic consequences of today’s UK Pound flash crash explained

Oh what a difference a couple of days make! It was only on Monday I wrote a post on here entitled ” Will this be seen as the sterling crisis of 2016?” and today we wake up UK time to see the UK Pound just above US $1.24 and at 1.12 versus the Euro. In fact this is not the half of it as the BBC points out.

The pound has dived on Asian markets with automated trading being blamed for the volatility.

At one stage it fell as much as 6% to $1.1841 – the biggest move since the Brexit vote – before recovering to $1.23, still down 1.5%.

It is not clear what triggered the sudden sell-off. Analysts say it could have been automated trading systems reacting to a news report.

There is a fair bit to consider and let me start with the debate over the basic facts as you see that it has also been suggested that the low was US $1.15 you get the idea. We saw this before when the Yen shot higher back in the day that there was considerable doubt to the exact numbers for a while. There are plenty of theories in the media that vary from unlikely to rubbish but Polemic Paine has written a good description of the way the market would have been.

But back to sales. Those that are still on the phone are quoting the reason for the fall on anything that they feel everyone else is saying because no one has a real clue. They will probably repeat what JPMChase or Goldman say as they reckon that the guys there are cleverer than them and more likely to know. So, clients will currently be being told that it is due to- “Barriers being hit at 1.25, 1.20 , and 1.15” and if they can’t even manage that will say “Stop losses”, which is a great generalised term that demands no justification. But some foolish folk will have done a Bloomberg News search for GBP and decided that it is due to the news that fracking had been allowed in North West England. Which is of course rubbish, because we all know that it happened because Diane Abbott was made the shadow Home Secretary.

For my own part I had a wry smile as only yesterday afternoon I was involved in a discussion about Goldman Sachs’ forecasting US $1.20 for the UK Pound which none of us realised was going to take less than 12 hours. My personal experience of such markets and I particularly think of the Italian bond market here is summed up again by Polemic Paine.

First, every salesperson is struggling to call all their clients who had ‘call levels’ at zones never expected to be hit, whilst trying to fill orders in systems at levels that they think they can get away with. Oh, hang on, no they can’t do that anymore as they need audit trails. So, they will all be huddled around spot desks arguing over whose order was hit at what……….Meanwhile, clients will be calling in demanding to know why their stops were done 7% below current market and why no one called them. Because if they had been called they would have bought it back at 8% below current markets because they are all retrospective geniuses.

Back in the days when the BTP ( Italian bond ) market swung wildly there was then a scramble to check stop-loss orders to find invariably that some had been forgotten in the melee. Because trading is now automated they should have been done except were ones that low even entered? Anyway a long day is ahead in dealing rooms just dealing with that and the recriminations. Meanwhile the media will have invented all sorts of stories which may or may not have any truth to them.

The economic impact

Much of this is uncertain and in fact the major initial impact is simply that uncertainty. This is the financial market equivalent of the night after the vote for Brexit as no-one will be exactly sure of what has just happened. However some things we do know as for example the UK Pound had been falling anyway and as I pointed out on Monday.

As we have fallen since then my estimate may now go as high as 1.5% for the boost to annual inflation.

We can add a little more to that if we stay here and of course there will be a boost to output but as I pointed out then it is much more difficult to quantify. This from the Market Purchasing Managers Indices is all we have so far.

rising demand from overseas clients linked to the weak pound sterling…….enjoyed the benefits of a weaker currency.

Another potential impact comes from the fact that due to more fears about inflation as discussed above the UK Gilt market has fallen heavily this morning. This is different to the UK Pound as it has lost some of its gains rather than adding to losses but if we continue like this there are two issues. Firstly the plan for an extended fiscal policy I discussed on the of this month as just got more expensive and secondly we may see some mortgage-rate rises. The prospect of the latter usually causes panic at the Bank of England in the same vein as Gollum in the Lord of the Rings worried about his precious.

To put this into numbers the 10 year Gilt yield has risen to 0.97% and for fiscal purposes the 30 year has risen to 1.68%. Both very low by historical standards but higher than they were.

Where was the Bank of England?

According to the Financial Times the UK Pound fell 6% in 2 minutes so we may ask where was the organisation which claims this?

Promoting the good of the people of the United Kingdom by maintaining monetary and financial stability.

It does have the ability to intervene and such a move is a clear case for intervention using this.

the Bank can intervene in support of its monetary policy objective using the Bank’s own resources rather than those of the EEA. (Exchange Equalisation Account).

As it happens it would have closed the position for a profit which is usually the case in such circumstances but not the reason for doing it. Does the Bank of England only work what used to be called gentleman’s hours?

Just as a pointer I have contacted them to say that the foreign reserves system is a mess and need reform. If I ever get a reply I will let you know.

Moving onto the economic position the Bank of England has its hands all over this and consequently a lot of egg on its face. What did it expect when it undertook Open Mouth Operations promising a monetary “sledgehammer”? Also I did point out on Monday that this statement from Dame Nemat Shafik could have been in the script for the film “Dumb and Dumber”

it seems likely to me that further monetary stimulus will be required at some point

Also there is the issue of this from Ben Broadbent of the Bank of England (h/t @LiveSquawk)

If sterling really starts to fall uncontrollably then it could have consequences for monetary policy.

And to be fair this bit turns out to be on the case.

the effect could be coming through faster than we’d anticipated

Having talked the UK Pound lower I suspect the Bank of England will be quiet for a bit or perhaps we will get some more like this from the FT about Governor Carney.

“In the absence of anyone else showing much economic leadership, this gives him a chance to shine,” said one Whitehall official. “He quite likes the media opportunities his current job gives him on the world stage.”

Right now it would involve yet another Forward Guidance U-Turn for him to support the UK Pound on the world stage.

Comment

There has been some economic news today which I will pick up in full detail another time as with markets in panic mode and the US employment report due later they will be ignored. Our persistent trade deficit persists and the small drop in monthly industrial production (0.4%) was more than explained by a fall in oil and gas (0.5%).

When this settles down we will have more idea of the full economic impact but I think John Lennon got it right all those years ago.

It’s been a hard day’s night, and I’d been working like a dog
It’s been a hard day’s night, I should be sleeping like a log

Those long the UK Pound may well have a different tune of his in mind though.

Help, I need somebody
Help, not just anybody
Help, you know I need someone, help

Will this be seen as the sterling crisis of 2016?

Sometimes events overtake us to some extent and the recent move has been a further fall in the value of the UK Pound £. Whenever this happens then old fears come to the surface and in many ways they are right to because such events have a mostly bad track record for the UK economy. However some things have changed as in the past we either had a fixed exchange rate or elements of one which meant that a problem, usually with the balance of payments could very quickly become a crisis as it did in 1967. Ironically later statistical revisions told us that it was in fact not necessary. Oh well!

This morning has seen the media out in full force on the subject of a lower UK Pound. From the BBC.

The pound dipped to $1.2766 in early trading on Tuesday – its lowest level against the US dollar since 1985.

Sterling has fallen sharply for the past two days as traders look to the Conservative Party conference for Brexit details.

Also the Financial Times.

The pound has skidded to a new three-decade low against the dollar as fears grow of a “hard” Brexit and its potential impact on the UK economy…..The pound has dropped 0.5 per cent against the greenback so far this morning to $1.2776, its lowest level since 1985.

The FT even gives us two reasons why.

a decline that has reflected the sharp deterioration in the outlook for the UK economy as well as expectations of further easing from the Bank of England.

I will come to the Bank of England in a moment but “sharp deterioration” is an interesting phrase from an organisation which you think might have been taught some humility by economic events so far after the vote to leave the European Union in the UK.

What about the Bank of England?

It should in my view be having a serious rethink this morning about its actions as its proclaimed “sledgehammer” for its monetary policy has no doubt contributed to pushing the UK Pound lower. I pointed out on BBC Radio 4’s Money Box program just over a fortnight ago that the lower UK Pound’s effect on the UK economy would be a “bazooka” compared to their “pea shooter” but even so some of the dimmer members at the Bank of England have been unable to restrain themselves. It was only on Thursday that I quoted these words from Dame Nemat Shafik and the emphasis is mine.

the process of adjustment can sometimes be painful. That’s where monetary policy can help, and it seems likely to me that further monetary stimulus will be required at some point in order to help ensure that a slowdown in economic activity doesn’t turn into something more pernicious.

Such pronouncements could be from the film “Dumb and Dumber” when you have already eased policy and have seen a substantial fall in your currency. Especially when you admit that things so far have turned out better than you had expected.

Bank staff have revised up their forecast for the mature estimate of GDP growth in Q3 to 0.3% from 0.1% at the time of the August Inflation Report.

Should tomorrow’s services PMI (Purchasing Mangers Index) turn out to be as strong as the manufacturing one (55+) and the construction one this morning which saw  a return to growth another Forward Guidance embarrassment will likely be in play.

How much has the UK Pound fallen?

If we look to the effective or trade-weighted exchange-rate we see that as of last night’s close it had fallen to 76.7 which compares to 87.7 on the day before the EU leave vote and 90.4 on the last day of 2015. As ever we have fallen by more against some of which one must be the Japanese Yen and maybe even gained against one or two such as the Nigerian Naira but not many.

What is the economic impact of this?

Applying the old Bank of England rule of thumb gives us a monetary policy stimulus equivalent to a 3% Bank Rate cut since the vote and one of around 3.4% since 2016 began. However this is a boost to both inflation and economic growth or if you like nominal output. To get the real gain we need to know how much of it will be inflation. Back on the 19th of July I did some calculations.

If we look at the way that the UK economy is relatively more open than the Euro area and the fact that our fall was more against the US Dollar in which many commodities are priced I expect a larger impact on the annual rate of inflation than the Draghi Rule implies and estimate one of say 1%.

As we have fallen since then my estimate may now go as high as 1.5% for the boost to annual inflation. Many factors are of course in play here and as we look at the numbers now a price for Brent Crude Oil of over US $50 per barrel does not help when you are buying with depreciated UK Pounds!

By contrast the output boost is much harder to get a handle on. We do get some evidence as this from the Markit Manufacturing PMI shows.

The weak sterling exchange rate remained the prime growth engine, driving higher new orders from Asia, Europe, the USA and a number of emerging markets…..the weaker pound also bolstered export orders which increased at the steepest rate for 32 months.

There was also some evidence of this in last month’s services PMI release.

Companies linked greater demand to new clients, higher export business linked to the weak pound, higher domestic tourism and returning confidence following initial disruption related to the Brexit vote.

We of course await tomorrow’s update on what happened in September.

Comment

Let me return to my title and look at the issue of a sterling crisis. A real old-fashioned one in the style of 1967 cannot happen now as we do not have any element of a fixed exchange-rate. Whilst we can still have a balance of payments crisis the thresholds are much much higher now. Technically we have had a depreciation rather than a devaluation. If we compare to the depreciation which followed the collapse of the Northern Rock Building Society then not that either as the UK Pound fell from an effective exchange-rate of 105 in July 2007 to 77 in March 2010. Oddly a rather similar number to now. If we go back to 1992 the fall then was larger as well as we fell from 98 in July of that year to 81 in February 1993 as we first fell within our ERM ( Exchange Rate Mechanism ) band and then fell out of it completely.

Thus in terms of past sterling crises this is relatively small so far and of course events may change course or get worse. One factor that is at play here is the world economy which is showing some good signs as for example China rumbles on and we see in response changes in the commodity price pattern. But on the other hand there is the issue of why the Reserve Bank of India has today cut interest-rates from 6.25% to 6% meaning that @ReutersJamie can tell us this.

It’s only Oct 4, but India’s rate cut today means central banks have already eased policy more times this year (102) than last year (101).

According we wait to see if the next pattern will be more like 1992 (good) or 2007/09 (not so good). Here is some perspective from Macro Trends

http://www.macrotrends.net/2549/gbp-usd-historical-chart-data