The UK and its currency are now perceived as a riskier bet. Sterling's decline may be telling us that overseas investors see a significant risk of inflation ahead.
This puzzles me. If sterling’s really fall is telling us that there’s a risk of inflation, then it should have been accompanied by a rise in the breakeven inflation rate (the gap between conventional and index-linked gilt yields). But my chart shows that the opposite has happened. As the pound has fallen, investors have become less worried by inflation, not more.
Now of course, it might be that the breakeven inflation rate is set mainly by domestic investors, and foreigners know something we don’t. But as there’s little evidence that foreign investors are better informed than local ones, this is improbable.
This doesn’t mean Julius and Gabay are wholly wrong, though. They’re dead right to say that sterling has become riskier. Evidence for this is that the rough pattern of sterling - a slump in the autumn, a weak mini-recovery in January-February and a fall earlier this month - is the same as global share prices. Changes in appetite for risk, as measured by changes in share prices, are accompanied by changes in sterling.
One reason for this might be that, as they say, investors don’t want to put money into economies dependent upon financial services, and stock market moves are a barometer of confidence in financial services.
Another reason is that sterling was buoyed up in the early 00s by carry trades - borrowing yen and Swiss francs to buy higher-yielding currencies like sterling. But the same liquidity crunch that hit shares also forced an unwinding of these trades, with the result that sterling fell and the yen and Swissie soared. The same crunch also caused fears of deep recession which have cut inflation expectations.
For this reason, I share Duncan’s relaxed view of sterling’s fall. It’s a symptom of a global problem, not a UK one.
There’s a simple test of this. If I’m right, then if (and it’s a big if) stock markets continue their recovery of the last few days, sterling too could recover.
It’s if this doesn’t happen that I’ll start worrying a little.
Now of course, it might be that the breakeven inflation rate is set mainly by domestic investors, and foreigners know something we don’t. But as there’s little evidence that foreign investors are better informed than local ones, this is improbable.
This doesn’t mean Julius and Gabay are wholly wrong, though. They’re dead right to say that sterling has become riskier. Evidence for this is that the rough pattern of sterling - a slump in the autumn, a weak mini-recovery in January-February and a fall earlier this month - is the same as global share prices. Changes in appetite for risk, as measured by changes in share prices, are accompanied by changes in sterling.
One reason for this might be that, as they say, investors don’t want to put money into economies dependent upon financial services, and stock market moves are a barometer of confidence in financial services.
Another reason is that sterling was buoyed up in the early 00s by carry trades - borrowing yen and Swiss francs to buy higher-yielding currencies like sterling. But the same liquidity crunch that hit shares also forced an unwinding of these trades, with the result that sterling fell and the yen and Swissie soared. The same crunch also caused fears of deep recession which have cut inflation expectations.
For this reason, I share Duncan’s relaxed view of sterling’s fall. It’s a symptom of a global problem, not a UK one.
There’s a simple test of this. If I’m right, then if (and it’s a big if) stock markets continue their recovery of the last few days, sterling too could recover.
It’s if this doesn’t happen that I’ll start worrying a little.
how much can be explained by demand for one of the UK's biggest exports (financial services) having fallen?
Posted by: Luis Enrique | March 13, 2009 at 01:42 PM
If you do a chart looking at Sterling-Yen versus the MSCI World Equity Index, the correlation is startling.
It is interesting though how many commentators/analysts are starting to worry about inflation.
I rather liked the fight on CNBC between Hugh Hendry and Liam Halligan on this issue on Thursday (video on my blog).
Posted by: Duncan | March 13, 2009 at 06:16 PM
Very good post. Thanks.
Posted by: David Heigham | March 13, 2009 at 07:06 PM
Indeed the sterling price has dropped againsed the dollar alot recently. But this gives the UK a better change at exporting there4 helping the UK manufacturing sector
Posted by: Worldwide Distribution | March 13, 2009 at 08:38 PM
This is not true. There are more complicated.
Posted by: David | March 15, 2009 at 09:08 AM
Breakeven inflation of late has been a faulty measure of participants inflation expectations.
As we all know, the BofE has launched a massive QE programme of repurchasing long term gilts. This has driven the yield of gilts lower, and since inflation protected Gilts has not been included in the programme, the BEI rate has plummeted.
Printing of money is always going to be inflationary.
Posted by: Amber | March 15, 2009 at 03:24 PM