As forex markets began their daily operations in the City of London yesterday, sterling was once again feeling the heat. Seemingly relentless downward pressure pushed the currency lower across the major pairs, and particularly versus USD.
The 1.3000 level that had provided solid support until late September is now long gone. It really is amazing how quickly the tides of fortune can change. Until 1.3000 yielded to lower levels, sterling actually looked like it possessed the potential to move higher in the longer term.
The nature of technical analysis is such that as one support level is broken. so another is sought.
For a while, the pound tried holding the line at GBPUSD 1.27-28. This did not last long as the weight of technical pressure simply added to the prospect that Theresa May's government was placing more effort in securing the nation’s borders as against remaining in the single European market; i.e. a “hard Brexit”.
Coupled with a warning from the Treasury that Brexit could cost see GDP fall by 10% and thus losses of up to £66 billion/year, and the headwinds were obvious.
Source: www.investing.com, Spotlight Ideas
Was this the reason for last week’s flash crash? There are many opinions on that subject ranging from a “fat finger” on a keyboard to the fear of an economic meltdown. What is clear is that the sharp spike lower has now created a potential target for a floor in the 1.2026 area.
As of 06:59 GMT today, GBPUSD was trading at 1.2262; therefore, such a target is not too far away.
How will the decline of sterling affect the UK economy regarding its ability to trade freely with the rest of the world? Can a more competitive currency dovetail with new trends in global demand and supply and so bring new opportunities for UK exporters that will generate sufficient revenue as to outweigh the cost of UK imports?
A favourable movement in the terms of trade may have an unfavourable effect on the trade balance, while an unfavourable movement in the terms of trade (export price/import price) may have the opposite effect.
This is because the terms of trade record relative price movements of exports and imports, while the current account of the balance of payments is concerned with export and import revenues, i.e. price x quantity bought or sold. An improvement in the terms of trade means that the price of exports increases relative to the price of imports.
Therefore, as sterling falls the UK is actually experiencing a decline in its terms of trade.
We cannot be too simplistic in this matter as the impact of a change in the terms of trade on the trade balance will largely depend on the price elasticity of demand (sensitivity) for exports and imports. In the current situation, a worsening of the terms of trade means that the price of imports increases relative to the price of exports.
However, there are further complications to be considered. The global economy is a dynamic environment and as well as considering the sterling exchange rate, one has to allow for changes in overseas income levels. This is particularly true in developing countries where the UK has a new trade opportunity for lower-priced exports to target rising incomes.
Therefore, it is important to understand how these influences are likely to impact the composition of import demand growth across sectors and on the types of goods and services in which the UK has comparative advantage.
The data, while admittedly a little dated, reveals that the fall in the level of sterling is most likely to boost UK exports of heavy engineering and machinery equipment to the BRIC nations and, surprisingly, Western Europe.
Source: UK Government/BIS
Source: UK Government / BIS
One can understand the opportunity that lies with the BRIC nations as they are both individually and collectively the fastest growing nations in 2016. They also possess a rapidly growing middle class that enjoys spending its wealth.
What seems at first a paradox is that the UK could be on the cusp of enjoying an excellent trading relationship, if said activity were free from penal policies following the Brexit vote.
One must recall that prior to Brexit, 43.5% of all UK exports went to the other European Union nations. Customers there have clearly expressed a high level of confidence in the quality of UK services and high value-added products. So if such items were suddenly available at cheaper prices, then it should augur well for the UK.
This has to be balanced by what type of relationship the UK will have with Europe once the prime minister triggers Article 50 by March 31, 2017. It is notable that the loudest voices for not given the UK an easy ride are either career bureaucrats who fear the UK decision could catalyse others to vote to leave the EU or politicians that are currently in a domestically tight spot.
Namely: Matteo Renzi in Italy and François Hollande in France.
That said, the elasticity measures illustrated in the second bar chart above do suggest the UK can seek further export opportunities in the Americas and Africa.
However, the net impact (provided the EU is not ridiculously vindictive) is that a weaker pound will boost exports, meaning the country should avoid a recession.
Urban decay in central Liverpool: A prolonged recession would be disastrous
for Britain's many languishing industrial cities and towns. Photo: iStock
To explain this, consider the Marshall-Lerner Condition which states that the current account will improve after a depreciation if the sum of the price elasticities of demand for imports and exports is greater than one.
My calculations for this paper are rather hurried and so genuine academic economists may well poke holes in the work, however I have weighted both the import and export elasticities on a regional basis and would suggest that the calculation should approximately be:
Weighted Export Elasticity -0.57 + Weighted Import Elasticity +1.68 = +1.11
The Marshall-Lerner condition is a medium- to long-term phenomena. Therefore, a deterioration of the trade balance may happen even though overseas demand increases because people overseas do not react immediately and so export demand will take time to change.
An initial deterioration of the trade balance follower by an improvement can be drawn in a graph called the J-curve which starts in the deficit area to a surplus area, thus going from negative to a positive area, forming the curve.
Source: Spotlight Education
The value of sterling, future trade relationships, the status of EU nationals in the UK, and other factors will all influence business confidence over the coming two to three years.
One thing that is likely to follow is the level of inflation will start to accelerate. Consumer prices rose 0.6% in the year to August 2016, unchanged from July while markets were expecting a 0.7% gain amid the weaker level of sterling.
Transport prices rose further and cost of food fell at a slower pace while lower prices for housing and clothing weighed on inflation.
That will signal an end to the cycle of Base Rate reductions from the Bank of England, however, if it proves to be the low water mark in Base Rate rates it may just signal the start of economic normalisation in the UK.
— Edited by Michael McKenna