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A Brief History of the UK pound (GBP) vs. the US dollar (USD)
Before WWII, and arguably after WWI, the British pound was the primary medium of foreign exchange, giving it a nominal premium over other currencies including the USD, with a pound fetching $5 and more. After WWII, however, the USD began it’s rise to become the pre-eminent currency in international trade and a global store of value. For example, today, the USD comprises over 60% of global foreign exchange holdings. Starting from those lofty valuations, the USD began to supplant the GBP, leading to a long slide in the GBP/USD rate over the succeeding decades.
The British pound (aka Sterling) has been nominally stronger than the USD for most of the past few decades, making a high just over 2.0000 USD per GBP around the time of the Great Financial Crisis (GFC) of 2008/2009. The GFC saw investors flee to the USD and out of the pound, among other major currencies. Once the GFC dust had settled, GBP had dropped to the 1.4000/4500 level. The GBP weakness was more a case of panic buying of the USD rather than any GBP-negative issue, as other major currencies weakened sharply against the USD as well (see long-term chart below).
In subsequent years, GBP/USD fluctuated between roughly 1.40-1.70, but then came Brexit in June of 2016, where the UK surprisingly voted to leave the European Union. The pound was knocked from the 1.40/45 area lower down into the 1.20/1.25 area virtually overnight, where it remained until recent events and market dislocations. The culprit this time is a combination of factors, chief among those is USD strength due to widening interest rate differentials in the USD’s favor. Along with higher relative interest rates, the US economic outlook is reasonably positive, while market watchers are soon to declare the UK is in or near recession. The pound is not alone in being sold against the USD, as investors fear a global recession and favor the greenback as a safe haven in times of economic distress.
Key Takeaways
- For over 20 years the GBP has been stronger than the USD in nominal terms.
- Brexit weakened the British pound on a structural level.
- The British pound is currently (Oct 2022) testing historically low levels against the USD
- The market is betting on a weaker pound going forward, potentially falling to or below parity
- Such a move could be met with intervention, but the BOE (Bank of England) claims not to have sufficient foreign reserves to make intervention successful.
Nominal Value vs. Relative Value
The nominal value of a currency is relatively arbitrary. What matters is how the value of that currency changes over time relative to other currencies. For over 20 years, one U.S. dollar has been worth less than one British pound. As of September 2022, the dollar is sitting around 1.1000 to one pound. This is down from 1.68 in May 2014 and 1.40 in March 2018. This trend is indicative of deteriorating economic conditions in the United Kingdom, mainly from Brexit, combined with an improving U.S. economy.
It’s also worth considering that many more dollars are in circulation than pounds. As of July 2020, nearly 1.93 trillion U.S. dollars were in circulation. By contrast, the total pounds in circulation came to a mere 70.16 billion. To draw an analogy, the 2020 market capitalization of Berkshire Hathaway Inc. (BRK.A, BRK.B) was much lower than that of Microsoft Corp. (MSFT) despite the fact that Berkshire Hathaway’s share price is much higher. This is because there are many more outstanding Microsoft shares than Berkshire Hathaway shares.
Consequences of Brexit
On June 23, 2016, British citizens went to the polls and voted in favor of a referendum to leave the European Union (EU), of which the country had been a member since 1973. The “Brexit,” or British exit, came about as a result of a populist movement that had grown weary of ceding control of laws and regulations to outside forces in Brussels. There was also a fear of the effects of what was viewed as unchecked immigration. Economists, most of whom were confident that Britain would vote to remain in the EU, warned of economic consequences that would result from Brexit.
The vote in favor of Brexit shocked oddsmakers and roiled world markets. It also had an immediate and pronounced effect on the British pound, which declined in value by over 8% in the 24 hours following the vote. This is another example of relative value trumping nominal value. While the pound remained stronger than the dollar in nominal terms, investors still abandoned the currency, citing its precipitous decline in relative value.
The pound has been turbulent and volatile since the 2016 Brexit announcement. Near the end of 2016 the GBP/USD reached lows around 1.20. In 2018 there was a slight rebound, peaking at around 1.40 in April 2018. Most recently, Sterling was trading below roughly 1.1000 against the buck, owing to concerns over global growth, the risks of a UK recession, and interest rate differentials vastly in favor of the USD. Market speculators may very well make a test of parity (1 GBP to 1 USD), and even lower, potentially giving the USD a nominal value above the GBP.
Why has the pound maintained a nominal premium to the USD for all these years?
Much of it has to do with the starting point of GBP/USD over a century ago. Sterling has been in a long downward slide against the greenback for many decades, owing to the USD’s rise to prominence, the growth of its economy, and GBP negatives, such as Brexit and a widening interest rate gap against Sterling, to name a few current factors. The nominal premium is not carved in stone and speculative and macro-economic developments may soon see the pound give up its nominal premium.
Does it matter if GBP/USD falls below parity?
It would certainly be a blow to the UK’s ego, but it won’t make a significant change to global currency valuations. A weaker pound is a double edge sword for the UK: a weaker currency is good for exports, which can bolster the economy, but a weak currency is also a driver of inflation (imports more expensive), which the BOE is legally obliged to contain. The risk is that a downside move in GBP/USD could become disorderly, for which the UK would need outside help (Think G7) to contain or slow the decline.
Which is more important: the nominal value of Sterling or the relative value?
A weak pound is a nominal construct as far as exchange rates go. However, if sterling should be seen to be diverging from other currencies as well, i.e. its relative value is falling across the board, it could provoke a run on the GBP, with speculative sellers the driving force behind that selling.
What does the new government’s tax plan mean for the pound?
The new government of Prime Minister Liz Truss has put forward a tax plan which heavily favors high earners and wealth holders. The market reception was not good, as markets view tax cuts for the wealthy to be counterproductive to economic growth and destabilizing the government’s fiscal discipline. As a result, GBP debt was sold off sharply, necessitating the BOE to step in and buy British debt. It’s unclear what the BOE’s staying power is if the markets decide to sell GBP debt again, but further weakness in the pound is likely to be better tolerated.
The Bottom Line
The British pound has enjoyed a nominal premium to the USD for many years, partly owing to historical convention and partly due to central bank and government credibility. All of that is under attack at the moment, with the new government introducing a deficit-blowing tax cut plan for the wealthy, widening interest rate differentials to GBP, and the looming prospect of a UK recession, possibly coupled with a global downturn.
Sterling is on the verge of giving up its nominal premium to the USD, but the market will do what it wants. The downside appears to be the current target zone, with parity (GBP/USD 1.0000) as the next point of psychological support. The biggest risk after another downside move, or a break of parity is for concerted G7 intervention to support the pound, as the BOE has signaled it does not have the resources to undertake meaningful market intervention. Traders and investors should concern themselves with the relative value of the GBP, the downside of which is currently under pressure.