It was 30 years ago Friday that the British pound got smacked out of Europe’s exchange-rate mechanism, George Soros became a household name, and John Major’s government was left embarrassed in an episode known as “Black Wednesday.”
Commentators were emphasizing the historic echoes three decades later as the British pound extended its stumble well below its September 1992 lows on Friday, sliding below $1.14 versus the U.S. dollar
to trade at its weakest since 1985. This time around, however, there were no hedge-fund billionaires or arbitrary exchange-rate straitjackets to blame.
However, the scale of the pound’s slide, leaving it below the low end of its 30-year range could tempt investors to conclude that further downside is limited, said Adam Cole, chief currency strategist at RBC Capital Markets, in a note. That might not be sound, he argued.
Cole, in the chart below, takes a look at the pound’s performance over the last 30 years and argues that looking at exchange rates in nominal terms over such long periods “makes little sense.”
The chart tracks the pound’s effective exchange-rate deviation from the 30-year average. In nominal terms, as shown by the blue line, it’s near the bottom of its range over the last three decades. RBC’s preferred measure, however, is based on relative labor costs, as shown in the black line. And by that measure, it’s near the top of the range, Cole observed.
“This of course reflects rapid labor cost growth in the U.K. relative to its trading partners, which has the U.K.’s poor productivity performance at its root,” Cole said.
“With the benefit of 30 years of hindsight, GBP (British pound) was undervalued before its Black Wednesday fall, which had more to do with unsustainable domestic monetary policy than the exchange rate per se,” Cole wrote.
Black Wednesday was among the most bone-rattling days in modern financial market history. The Bank of England, which was then under the direct control of the U.K. government, hiked its official interest rate from 10% to 12% and then to 15% in a single, chaotic day as it attempted to maintain the British pound’s membership in the European exchange rate mechanism, or ERM. The ERM was designed to reduce exchange-rate volatility and promote monetary stability.
For the U.K., the ERM effectively amounted to a pledge to keep its currency at an exchange rate of more than 2.7 German deutsche marks to the pound.
As they tend to do, traders sniffed out weakness, viewing the hikes as desperate measures unjustified by Britain’s underlying economic fundamentals. They put the Bank of England to the test, continuing to sell the pound and eventually forcing the government to give up the fight and return the official interest rate to 10%.
The pound fell sharply and Britain dropped out of the ERM, leaving Prime Minister John Major’s government humiliated. Soros, who had placed huge bets against the pound, was said to have made around $1 billion in the episode and became forever known as the man “who broke the Bank of England.”
Comparing fundamentals, Cole noted that the U.K. current account — the tally of a nation’s transactions with the rest of the world, including net trade in goods and services, net earnings on cross-border investments and net transfer payments — was close to balance in 1992. It now stands in deficit of 4% of gross domestic product, further suggesting the pound is overvalued now compared with then, Cole said.
To be clear, valuation alone isn’t a reason to be bearish toward the pound, Cole said, noting that deviations from competitive fair value can run for long stretches without correcting. Looking at the most meaningful measures, however, makes clear that the pound’s current level “is not an impediment to further significant falls, based on the structural and cyclical factors that we have identified,” he said.