The Story
After the announcement of a 50-basis point rise in interest rate to 2.25% by the Bank of England and the UK’s finance minister’s announcement of tax cuts, the pound slid to an all-time low against the dollar. On Monday the 26th of September 2022, GBP/USD traded at a low of 1.0345 pounds to a dollar.
What exactly is going on in the foreign exchange market?
The Pounds Sterling is one of the few currencies that is stronger than the US Dollar. Though the dollar dominates international transactions and is the reserve currency in most countries, it has never been as strong as the pound sterling in the foreign exchange market.
In the foreign exchange market, 3 currencies are safe havens that investors run to in times of uncertainty. They include the US dollar, the Japanese yen, and the Swiss Franc. Financial markets have been in disarray since the beginning of 2022 and there has been a lot of uncertainty in the global economy.
This has led to a significant rise in the value of haven currencies like the dollar and Swiss franc. The haven currencies have attained record high levels against other currencies. The Japanese yen has also not fared well given the peculiarities of the Japanese economy.
The US federal reserve in its fight against inflation has taken on a very aggressive approach or hiking interest rate hikes. In the forex market, the currency with the higher interest rate is favored by investors. This accounts for the domination of the dollar in the forex market in 2022 with year-to-date gains of over 18%.
Is this why the pound is trading at an all-time low against the dollar?
The rise of the value of the dollar partly accounts for the doldrums of the pounds. There is also the performance of the UK economy in 2022. The UK economy is believed to have slipped into a recession. To cushion the effect of the harsh economic realities of a recession and attract foreign direct investment, the UK government proposed tax cuts which the market reacted negatively to. This led to the UK prime minister taking a back step on its decision to cut taxes and firing the finance minister, Kwasi Kwarteng.
What are the implications of a declining pound on the UK economy?
The fall in the value of the pound implies the price of imported goods into the UK will rise. Companies will also have to deal with more expensive imported raw materials. This also implies that exports from the UK will be cheaper as buyers of UK exports will have to spend less.
It is however important to note that the pound is not depreciating against all currencies, it is depreciating against the dollar and a few other strong currencies. It is still stronger than the Euro, the yen and a couple of other currencies.
Given the fact that the Europe remains one of the UK’s largest trading partners, the effect of a declining pound may not be as severe as expected.
What does this mean for investors in and outside the UK?
Non-resident Investors with dollars to invest are at an advantage as they can invest in high ticket assets like real estate at lower prices. For investors earning in other currencies, the value of the British pound compared to their local/earning currency will be a determining factor.
Resident Investors will have to pay more for dollar assets and given high inflation and ongoing recession, they will have to take strategic positions with their investments.
In reaction to an expected increase in government borrowings, yield on British bonds have risen to record levels. Investors can take advantage of this to get attractive returns in an inflationary environment as well.
