In addition to the fact that the pound itself has a rather tense relationship with the US dollar, Britain's currency is also threatened by the policy of Britain itself. How serious is it?

GBP/USD: falling to parity no longer a fairy tale?

If we analyze the moments of history when the dollar bit off the pound hard, the government tried, but failed to protect the national currency both times. This at one time cost John Major, and even earlier Harold Wilson, the prime minister's chair and almost ruined Churchill's career.

Now investors are again hotly discussing parity against the dollar after the British currency fell today, May 12, after announcing unfavorable GDP data for the first quarter. And, despite Johnson's desperate struggle with inflation against the background of the Russian-Ukrainian conflict, he is quickly losing political points in this unequal battle.

What are the chances that the currency will stop declining in the near future, and what will be the consequences if this does not happen? We are sorting it out.

Parity in the past

There have been similar fluctuations in the past. After the abolition of fixed exchange rates in 1971 according to the Bretton Woods Agreements, the pound was already approaching the value of the US dollar. It happened in 1985.

This case has entered all textbooks of economic theory as a situation provoked either by the words of a politician, or by the words of a newspaperman.

That year, the Federal Reserve managed inflation by attracting funds from Britain. The smooth depreciation of the pound at some point turned into a steep peak. After Margaret Thatcher inadvertently warned the public that the market could really give global preference to the dollar over the pound, an article was published in The Times. In it, reporters indicated that Thatcher was ready to equate the pound to the dollar, portraying this as recognition and partial surrender. The markets reacted immediately.

Since then, politicians have not ventured to speak about their concerns directly, and the pound has in its own difficult history an incident of a sharp fall against the dollar.

In fact, Thatcher made every effort to protect the pound.

So, the Bank of England (BoE) began to promptly raise rates to protect the currency, and at some point the pound stopped falling at $1.05. More situations close to parity have not happened in the history of the GBP/USD pair. Only briefly did the exchange rate fall below $ 1.2 – immediately after the Brexit referendum in 2016 and in the first days of the pandemic two years ago. Now the situation risks repeating itself.

On Wednesday, May 11, before the end of the London trading session, the pound was worth $ 1.2251 - a low it has not seen since May 2020, when the global economy was pierced by pandemic fear.

As you know, rounded numbers are of great psychological importance in currency trading, so the next key level for the markets will be $1.20.

Actually, after the historic fall of the pound in 1985, it fell below this critical mark for many only during the most severe political crisis due to Brexit and in the early days of the pandemic.

Both of these cases are exceptional in themselves because of their large-scale and radical uncertainty about risks - risks at a level where it is difficult for markets to measure their scale in principle.

This time it's easier, because such crises are cyclical for the economy. They are usually explained simply - the main problem of currency markets in difficult times - by fears that high inflation and weak economic growth will make it impossible to further strengthen the pound.

And as in 1985, it is the words of the country's leadership and officials of the BoE that will be crucial in many ways.

Soft rhetoric, tough measures

This time, despite the measured words of the central bank, the GDP data for the first quarter provoked an attack on the pound. But even before that, the central bank of Britain allowed itself a frankly honest and bold statement that, most likely, the inflation rate in the country will exceed 10% and British production may well cover the basin of recession.

The markets immediately accepted these words exactly as they accepted Paul Volcker's words 40 years ago that inflation was out of control of the government - a large-scale panic. What in the history of economics was dubbed later as the "Volcker moment".

The most interesting thing in the current situation is that the loud statement of the BoE had the opposite effect in comparison with reality.

Mark Chandler, chief market strategist from New York, notes that the Volcker moment "crushed" the pound: "You have to be careful what you wish for. They say that central banks raise rates until something breaks, and the Bank of England says that something is about to break."

How did investors accept the bank's words? As a direct confirmation that the BoE has exhausted its resources and will no longer be able to interfere so actively in the exchange rate of the pound, raising the interest rate several times, and even by a significant difference. This does not mean that this is actually the case. But this is how investors accepted this message.

Meanwhile, officials of the US Fed made a much more restrained and optimistic statement, directly indicating that it is able to raise rates many times before the end of the year without the unemployment rate increasing too much.

Ironically, if you think about it a little, you will realize that the situation with multiple rate increases is exactly the opposite - very bad. Since multiple increases can only mean that they don't work every time.

As for the interest rate itself, as we know at least from the recent history of Russia, it can rise to at least 20%. So the BoE is not really limited either in the number or in the volume of rate hikes.

Nevertheless, the markets managed to re-accept the information "on a broken phone", and the fire broke out.

This is not an isolated case.

The bond market as a whole shows that traders tend to believe the Fed more, but not the Bank of England, although, as we can already see, it is the latter's rhetoric that is more truthful and balanced.

Typically, British securities offer higher yields than US Treasury bonds. This, in particular, works on the exchange rate of the pound, making British deposits more attractive. Alas, after the Brexit referendum, the island's bonds regularly trade below their US equivalent, and this weakens the pound.

Usually the practice in such cases is to blame "foreign influence".

In 1968, Harold Wilson accused the "gnomes of Zurich" of devaluing the pound. Twenty four years later, in 1992, George Soros, a hedge fund manager, became the scapegoat, publicly stating that the BoE would not be able to raise rates high enough to maintain the peg to the Deutsche mark.

However, this time is also unique in its own way, since the rhetoric of central bank officials is dangerously mixed with the government's course to continue and deepen Brexit.

The price of independence

If you remember, the referendum in June 2016 led to a fall in the exchange rate overnight by more than 10%, causing even fears that the British economy would not survive. And although this did not happen, the pound did not manage to fully regain its positions. Since then, its June 2016 level has served as a kind of beacon for all traders. And to this day, the opinion that the UK's withdrawal from the European Union makes its currency more vulnerable prevails among international traders.

Yes, there are economic arguments in favor of Brexit making the UK more vulnerable to restless investors, but political independence has a price, and it is also expressed in the exchange rate of the national currency.

Nevertheless, the goals of the Brexit organizers to "regain control" have obviously not been achieved, and the current jump in the pound confirms that the UK now has less control over its currency.

Moreover, economists reasonably believe that Brexit has directly increased the inflationary pressure that is now hitting the British economy.

Forecasts and arguments

Ian Harnett from the research company Absolute Strategy Research Ltd notes that standard quarterly surveys of enterprises about obstacles to their production work as a predictive indicator of inflation (actually, this is true not only for Britain).

When the proportion of companies that expect a shortage of employees or other factors to reduce their production over the next three months increases, then the inflation rate tends to rise in the future in a year. This is because the demand for labor forces companies to raise wages, which they then shift prices to the buyer.

If we take this CBI indicator as a basis, then everything looks very ominous, because right now it shows that the shortage of labor is the most serious since the stagflation of 1973.

How much does Brexit have to do with this?

The question is not idle, because Europe is the same for Britain as Mexico is for the United States.

Before Britain left the union, the latter was a generous supplier of cheap labor to the UK - at the expense of poorer European countries such as Romania.

In social terms, this eventually led to negative consequences, which led to the referendum (including), but also this factor restrained inflation and pushed the pound up.

In the era of the pandemic, the CBI indicator once again reminded us that every coin has two sides. With this in mind, companies' attempts to adapt to the new immigration system will be defeated this year, as the pandemic has forced many emigrant workers from the EU to leave the UK. The result is an acute shortage of labor, although there is a chance to improve things at the expense of refugees from Ukraine.

Effects

If we consider the situation of a weak pound, parity against the dollar will make imports more expensive, which this year outweighs the bonuses from a strong pound for exports. In turn, this can make inflation in the UK truly frightening, and it is still difficult to understand what the UK can do about it.

After the above, it is obvious that for now the fate of the pound remains in the hands of the US and the Fed policy.

Now we have to ask the question: and will the dollar really be able to continue strengthening for a long time, and how long will the Fed be aggressive before facing its own macroeconomic constraints?

The US position is unique. Many other countries around the world have varying amounts of national and corporate debts denominated in dollars. But, on the other hand, US multinational corporations do not like it when a strong dollar devours profits from exports, the level of which in the US, although it has decreased, is still very impressive.

The last time the dollar rose so much, the Reagan administration came under enormous pressure from manufacturers to weaken the currency. Actually, its efforts were aimed at this by concluding the Plaza Agreement of 1985 on international interventions to limit the growth of the dollar and the pound eventually received an increase.

This time, as then, parity will probably be avoided, but only because at some point a super-strong dollar will force international companies to lobby for this option in parliament. Of course, at another time, the Fed would have had a different lever as tax breaks and subsidies, but not in conditions of such strong inflation.