The value of the £ and playing for safety

The value of the pound is determined by just one thing – buying and selling by foreign exchange dealers.

When dealers sell the pound, it falls in value compared to other major currencies: when they buy pounds its value goes up.

Economists and the media like to surround the subject with an aura of mystery and complexity which only they fully understand – “market sentiment”, long-term economic projections, the financial outlook, the the Bank of England’s Monetary Policy Committee, the Treasury’s forecast, the Chancellor’s budget.

But the fact remains that not one of these people – not the Chancellor, not the Governor of the Bank of England and his nine wise men, not the IMF, not the entire staff of the London School of Economics, and not a single financial editor, knows what will happen to the economy or the pound tomorrow, next week or next year.

They, and we, are not normally compelled to face up to this awkward fact because for most of the time life just rolls on day after the day, much the same as yesterday and the day before. This illusion of consistency is dignified with the term “market confidence”. It also leads to the experts deluding themselves into thinking they understand the markets.

But every so often, something happens to shake us out of our complacency and reminds us that life is basically unpredictable – the Brexit referendum result or the election of Trump to the Presidency.

These shocks remind us that we have no idea what to expect tomorrow or the day after and in this unwelcome state of realism we all tend to react in the same way: we play for safety.

The governor of the Bank of England issues stern warnings about “a period of uncertainty” (meaning I don’t know what’s going to happen next). The Treasury informs us that the country “may be facing a range of economic outcomes” (meaning we don’t know what’s going to happen next). The International Monetary Fund reports “the possibility of negative influences on the UK’s economy” (meaning we don’t know anything either but we’ve got to say something – after all, we are the IMF).

You have to feel sorry for the poor foreign exchange dealer, sitting in front of his computer screen in his red braces chewing his HB pencil. Usually all he has to do is roll up to work, do a few trades – you win some you lose some – eat a decent lunch with the chaps at the club and go home to the wife and kids in Weybridge.

Now suddenly the whole world is breathing down his neck and the fate of the economy depends on which button he presses. And of course, his job is now on the line. It’s OK to make a small loss now and again normally – we all screw up sometimes – but now the spotlight is on every single trade he makes. Memos are written from the top floor. He can’t afford to lose a single penny, cent – or, indeed, yen, baht or yuan.

What does he do in these circumstances? He sells Sterling.  If he has any pounds he sells them and buys dollars or euros. If he wears extra large red braces, he may see a chance of making an honest bob or two by selling Sterling short – that is, contracting to sell at some future date in the hope of a decline in the market price.

In foreign exchange dealing, this is a self-fulfilling  prophecy because logically you can only sell one currency by buying another. If I contract to sell pounds for dollars I am automatically taking a net short position in pounds and a net long position in dollars. I’m not just weakening the pound, I’m also strengthening the dollar at the same time.

How long will foreign exchange dealers continue to short Sterling? For as long as the mood of realism persists, leading them to play for safety out of fear of making losses.

Sooner or later, the shock of Brexit and Trump will fade and they will forget that they haven’t a clue what will happen next. The moment even one dealer thinks that Sterling is undervalued and smells some profit to be made out of buying pounds and shorting dollars or euros, the pound will start to rise again.

 

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