Sterling Sinks

By Jake Rickman​

What do you need to know this week?

The pound is down. Massively. As of yesterday, the pound is £1.08 to the US dollar, having fallen as low as $1.03 on early Monday morning, which is the lowest it has ever been.

The sterling sell-off followed the announcement of the new government’s “mini-budget” that, in an attempt to stimulate the economy, will implement a host of aggressive tax cuts (see our accompanying article on the government’s new fiscal strategy).

Why is this important for your interviews?

Currency markets are inherently volatile. Investors tend to view currencies as proxies for the strength or weakness of the domestic market(s) behind the currency in question. Therefore, changes to rates of inflation, employment, borrowing, imports, and exports often influence currency prices.

The pound’s plummet is particularly worrying because the rate at which it has fallen is unprecedentedly steep. In fact, these sorts of market movements are what investors expect from the currencies of developing countries rather than OECD nations like the UK.

The emerging consensus is that investors are baulking at the new government’s fiscal policies. The decision to slash taxes while simultaneously borrowing upwards of £45bn to fund the tax cuts and energy subsidies is itself quite controversial. But many analysts see the new fiscal stimulation strategy as fundamentally at odds with the Bank of England’s attempt to wrangle inflation, which a day prior to the announcement raised interest rates a further 50 basis points.

We now have a tug of war between the BoE and the Truss government. The mini-budget effectively neuters the effect of a rate rise because the government must borrow money to fund the tax cuts and energy subsidies by issuing sterling-denominated bonds (“gilts”). This essentially means flooding the market with more sterling than there is investor demand. As a result, the price of sterling falls relative to other currencies. Investors do not feel confident in the value of the pound in the long term. Not to mention that the UK economy has contracted for a second successive quarter, which means we are in a technical recession.

This has potentially profound implications. The price of any goods imported into the UK increases for every penny the pound drops. If global inflation persists (as it is forecast to do), those paying for imports in pounds are hit doubly as hard. This is because it takes more pounds to buy the same goods than it did before. This effectively constitutes a new cost pressure on businesses and consumers that rely on imported fuel, commodities, and manufactured goods.

That said, we should also bear in mind that currency markets are trades on the ratios between two different currencies. One currency surging in value means another will fall. Therefore, while the pound’s cratering is significantly owed to investors souring on the UK market, the US dollar is also surging upwards, pointing to factors outside of the UK’s control.

How is this topic relevant to law firms?

Companies that trade in more than one currency often want to hedge their exposure to currency market fluctuations. One of the most efficient ways to do this is by locking in the price at a future date by entering into a contract guaranteeing the company’s right to acquire (for example) $100,000 for £90,000 (reflecting an exchange rate of $1.11 per £1.00). If the price of the pound falls (as it has) to less than $1.11 at the point the contract matures, the company has shielded themselves.

These kinds of contracts are called currency futures and are a kind of derivative. Linklaters is widely considered one of the best law firms advising on derivatives.