When you see a currency fall to the tune of 20% or more, you generally associate the decline with an emerging market or one that is mismanaged or run by corrupt ministers in a developing part of the world. But when that sort of move is seen in a currency such as the pound sterling, then it is an entirely different matter altogether.
Let's not forget this was the currency of one of the biggest empires of the world, one that colonized half the world less than a century ago. Its banking reforms and offshore banking protocols are some of the strongest and most pertinent as institutions and funds have built tons of assets around it given its "safety" and "security," or so one thought.
The sterling went through an abrupt correction post-Brexit, for logical reasons. Since then, just this year alone it has moved from 1.40 to the U.S. dollar down to 1.03 at one point this week. It has now rebounded off the lows. However, one also can assume such moves in the euro, which has seen its fair share of crisis over the past few years.
So, what is causing this slide in the sterling?
Inflation has been a truly global phenomenon since central banks embarked on this Modern Monetary Theory (MMT) journey, but Covid really made matters worse as the banks jumped to print so much money in such a short time. Consequently, inflation shot up north of 10% year over year in some places.
Long after the recovery, the Bank of England should have started raising rates and tightening liquidity, but it like the US Federal Reserve it also feared bursting the debt bubble or hurting consumers, who were getting more and more hooked on lower rates. Despite constant insisting of the non-transitory nature of inflation by their own bank, UK bonds just like US bonds have been signaling distress for some time. The bonds have been selling off all summer and beyond, with the UK 30-year gilt bond market trading close to 5% from just 1% in less than a year's time.
The rate of change of such a move is historically significant. We have not seen this level of yields since the 2008 Lehman crisis. But it is not the level as much as it is how fast we got there. The same is the move in all bond markets across the developed countries.
Pension funds and asset/liability-matched entities rely on these long-term bond markets to meet their liquidity and funding requirements. When we see such drastic moves in one, the balance is upset. This is what happened in overnight UK markets this week when UK gilts were causing pension funds to sell off holdings as they received margin calls and had to meet their liquidity requirements.
The UK bond market was on the cusp of coming to a halt, and this is no joke for a market like the UK. Hence, the Bank of England had to issue up to £65 billion to buy back their long-term gilt. In layman terms, this means they are basically doing quantitative easing. At a time when UK economy is experiencing inflation closer to 10% given its energy/gas problem, it decided to print even more money. One wonders why these bankers are sitting where they are, because in Classic Inflation 101, this move is going to trigger even more inflation, not ease it.
Just like the Japanese bond market and the Bank of Japan, an indebted central bank can have either a strong bond market or a strong currency -- it cannot have both. It is a wonder we did not learn from Japan, which went through all of this 20 years ago, yet we decide to make the same mistakes.
As there were rumors of UK funds freezing, which is the flashing red warning signal for any of the past crisis, the central bank had to step in and did what it knows best -- print more. That is why the sterling fell 5% on this news as the market knows fully well that, just like the yen, the sterling along with euro has no turning back.
The US Fed is perhaps the lesser of the evils as it, too, faces the same inflation crisis, but it has been vigilant about reversing some of its mistakes and is now tightening. As is typical, the bankers play backward-looking roles and are always late to the party, which creates massive tops and bottoms. For now, the fate of these developed-market currencies is dependent on the US Fed reversing its course. Until then they are the mercy of their own incompetent central banks that keep printing more each time there is a problem, making inflation almost certain for years to come. Welcome to the 1970s!