7 October 2016

There’s no need to panic about the pound – yet


Last night saw a “flash crash” in the value of the pound: sterling’s value fell, suddenly, by around 6 per cent, within a few minutes, rising back again. Such sudden crashes are often attributed to a “fat finger” effect, basically a transcription error. That might mean the order was supposed to be for the sale of, say, £1000000000.00, but instead it was entered as £100000000000 – ie was £100bn instead of £1bn, 100 times as large as intended. Or perhaps the offered price was meant to be $1.25 per pound but instead that was mistyped as $1.15.

These fat finger effects can be amplified by modern “algorithmic trading”, or high-frequency automated trading systems, whereby decisions over certain sorts of trade are either so large that they cannot all be executed at once, or occur so rapidly that humans only decide on the overall strategy rather than the individual trade, each individual trade being managed by a computer programme. Fat finger errors can lead computer trading systems to protect their positions by selling suddenly when the mistake drives down the price.

It might be that the pound is currently vulnerable to such strange spikes because traders suspect it could fall sharply for good market reason – so when a large move is seen it isn’t initially regarded as an error. That means that there might be relatively few programmes or traders who would take the opportunity of a sudden fall in the value of the pound to buy, bidding its price back up.

The pound’s value against the dollar has been widely covered in the press recently, with various lurid headlines about it being at its lowest level for 30 years. That’s true against the dollar, but a large part of that is a reflection of the differing interest rate expectations for the US Federal Reserve as against the Bank of England. Eighteen months ago the Bank of England had been expected to be raising interest rates, along with the Fed. Instead, the Fed has entered a rate rising cycle while the Bank of England first delayed rises then cut rates further in response to the Brexit vote.

Against other currencies, the pound has not done so badly. The chart illustrates that the trade-weighted index for sterling (its average exchange rate against all other currencies) is currently at about at the level that was typical from 2009 to 2013, or again was normal in the mid-1990s. It fell from late 2015 (at which point it was said by the IMF to have been significantly over-valued) as the world economy turned downwards (always likely to hurt the UK more than many of our trading partners, because of our high exposure to global trade and finance). Then it fell again after the Brexit vote.

The overall drop of around 20 percent from late 2015 should provide quite a material boost to UK GDP (and inflation) in 2017 – something of the order of 0.5-1.0 per cent extra growth, probably largely offsetting the negative impacts of the Brexit vote on investment. I’ve pencilled in 2 per cent growth for 2016 and 1.7 per cent for 2017, or of the order of 0.4 percentage points per quarter – slower than the 0.6 per cent of recent quarters, but by no means a disaster.

Where it stands, the pound is probably more helpful than unhelpful to the economy. If it were to fall much further, however, the Bank of England might need to consider raising rates rather than cutting them. That could put the Brexit cat amongst the financial market pigeons. Watch this space.

Andrew Lilico is Chairman of Economists for Britain.