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Stop looking for a bogeyman to explain sterling’s collapse

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When a currency plunges into crisis, it is common to seek out someone to blame. Eight years ago, in Ghana, “dwarfs” and “black magic” took some of the heat for a collapse in the cedi. In Turkey, President Recep Tayyip Erdoğan has frequently lashed out at a shadowy “interest rate lobby” for its supposed efforts to hammer the lira. In both cases, market-unfriendly policy mixes were more obvious culprits.

Now the pound is feeling the sting of financial market opprobrium. Like every other major currency, it has been under pressure against King Dollar for months. (Energy independence and a hawkish central bank are wonderful things for those who like the old “buy dollars, wear diamonds” adage.) But Friday’s woefully misnamed “mini-Budget” pushed sterling firmly over the edge.

It tanked by a massive 3.5 per cent against the dollar after new UK chancellor Kwasi Kwarteng cut taxes and boosted borrowing to juice up economic growth and fund the country’s response to the energy crisis.

A quick one-off currency decline is one thing, but the start of trading in Asia on Monday brought a 4 per cent drop against the dollar to a record low of just under $1.04. It is not a good sign that the market could not find natural buyers until it hit that point. The financial crisis, Covid and the exit from the European Exchange Rate Mechanism all hit the pound hard, but nothing has ever pushed it this low before.

The whiff of a chance that the Bank of England or Treasury might do something to stop the rot helped to lift the pound later on Monday, but it soon became clear no immediate help is coming, leaving the rate under $1.07, still the weakest point since 1985. Citi called it a “currency crisis”. JPMorgan said this all reflects the “erosion of credibility” on fiscal policy in the UK. Investors are betting that the BoE will have to push up interest rates aggressively to turn this around, possibly including rate rises between scheduled meetings, with rates expected to hit 6 per cent by May.

Some of the elaborate efforts to explain this collapse in sterling do not bear much scrutiny.

One of those is that this is the work of the dollar. It is true that even after an extraordinary 20 per cent decline this year — worse than most emerging-markets currencies — the pound has still fallen less against the dollar so far in 2022 than the Swedish krona or the Japanese yen. But nothing dollar-moving occurred at the same time as the mini-Budget to force this sterling move. It is worth noting that the pound fell by a similarly ugly degree against the euro, and the lira and cedi for that matter.

Another is that the BoE is to blame for opting to raise interest rates by less than some other big central banks. This is a tricky square to circle. The BoE started raising rates last December, months before its peers. Yes, it probably needs to jack up rates much faster now, if it wishes to try to stop the drop in the pound from imposing more upward pressure on imported inflation. But it could not have known this a day ahead of the mini-Budget — a quiet day for the pound — and it is hard to believe an extra 0.25 percentage points on Thursday would have made any difference.

Now, as Elsa Lignos at RBC writes, the BoE is “more at risk than ever of being painted as political . . . If they avert a collapse in the pound with higher rates they will get no credit for the hypothetical crisis they averted but reap plenty of opprobrium for raising borrowers’ costs.”

Another bogeyman is hedge funds. For some, they are to blame for profiting out of the drop in sterling. Undoubtedly, they have been big buyers of dollars for months, and many speculators have been aghast at new prime minister Liz Truss’s economic platform since before she took the job. Some will have had a very good day on Friday. But analysis from Swiss bank UBS suggests that as a whole, they were actually long, not short, sterling, in the lead up to the mini-Budget. “That helps to explain the extent of the scramble” to get out on Friday, says James Malcolm, head of foreign exchange strategy at UBS.

Optimists will insist that the market has got this all wrong, and maybe they are right. Some soothing words from the government to better explain how it will balance the books or fire up economic growth would help in that regard. And no one can rule out a short-term bounceback. “Give sterling a chance,” wrote Malcolm. But it is clear that investors do not like what they have seen. Blaming nuances and technicalities will not wash.

katie.martin@ft.com

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