Surging dollar means parity is still a threat despite the pound’s revival

There is no magic way to shore up the currency – and attempting to carries risks, writes Eir Nolsøe

After a rollercoaster ride, the pound has pulled back from the brink of parity with the dollar, defying the doubters who suggested that it was all but inevitable at the start of last week.

Market turmoil sent the pound the closest it has ever been to parity, reaching a record low of $1.035. But it ended Friday up at $1.115 after its best week since July 2020.

While the threat has receded for now, it has not disappeared altogether. Like most currencies around the world, sterling has struggled to keep up with the dollar since January.

The strong US economy and the Federal Reserve’s aggressive rate rises have pumped up the dollar. The pound may be down 18pc since the start of the year, but the euro is 14pc weaker and the Chinese renminbi has dropped 11pc against the greenback.

The dollar has been so rampant that the Bank of Japan was recently forced to intervene in currency markets to prop up the yen for the first time since 1998. It spent an estimated $21bn (£18.7bn) trying to support its value, according to the Nikkei, but the impact was short lived.

In Britain, markets are still placing a one in five chance of sterling reaching parity by the end of the year.

Wall Street banks such as Citigroup, Morgan Stanley and Bank of America are all betting on it by the end of the year – although other experts believe it is increasingly unlikely.

Roberto Mialich, foreign exchange (FX) strategist at Unicredit, said the recovery means the pound is now unlikely to fall below $1 and he expects it to end the year modestly lower at $1.07.

However, there is no “magic wand” to bump up sterling, according to Jens Nordvig, a Danish economist. There are several options, but they all come with drawbacks.

The classic way of supporting the pound is by raising interest rates. The Bank of England has already taken borrowing costs to their highest levels since 2008, but this has so far failed to support the pound as the US Fed – the central bank that calls the global tune – has moved further and faster than Threadneedle Street.

More interest rate rises are also practically limited by the impact they have on the economy, says Brent Donnelly, president of Spectra Markets.

“The more the Bank of England hikes, the worse it is for discretionary income and the worse it actually is for the pound in a counter-intuitive way,” he says.

“That doesn’t match how it normally works in G10 foreign exchange markets, but that’s how it’s working now.

“To get back to the friendly regime, you have to be in an environment where rate rises are responding to growth, not to inflation. That’s not going to be happening in this cycle.”

Another more niche option for shoring up the pound is currency intervention, à la the Bank of Japan. This is when central banks use their foreign reserves to buy large quantities of their own currency, driving up demand and so boosting the exchange rate.

Currency intervention is not a feasible option for Britain, according to Nordvig. The UK’S foreign currency reserves are small relative to the size of its economy. At the end of August, Japan had $1,173bn in reserves, Switzerland had $860bn and Korea $436bn. The UK, meanwhile, only had $108bn. That is too small to make much of an impact on the vast currency markets.

“It has not been a priority of the UK as a nation to build a big war chest in terms of currency reserves,” says Nordvig. “So there’s not really any meaningful firepower there.

“Currency markets are extremely big and 100bn doesn’t get you very far. So they will probably do 20-30 billion quickly and realise it doesn’t do anything. Then speculators would know now they have nothing left and the risk [that comes with] speculation will go down. Then the pound probably collapses even more.”

The last time Britain tried to manipulate the exchange rate was when the country crashed out of the Exchange Rate Mechanism in 1992. The then government raised interest rates to 15pc to save the pound and the Bank of England sold $40bn worth of reserves in the months leading up to Black Wednesday. The Treasury put the final cost of the episode at more than £3bn in 1997.

Both higher interest rates and currency intervention therefore risk harming rather than helping the pound. But some economists believe that there is a simple but unlikely solution to help stave off parity.

“A route one approach would be an about-turn on fiscal policy, which seems highly unlikely,” says Chris Turner, head of FX strategy at ING.

Some of the recent weakness seen in the pound came after the Chancellor’s fiscal statement, which spooked investors at a time when global market confidence was already incredibly shaky.

But there are signs that this shock may already have passed. Kwasi Kwarteng and Prime Minister Liz Truss’s meeting with the Office for Budget Responsibility last Friday helped shore up confidence and erase the losses seen for the pound in the wake of the mini-budget.

Kallum Pickering, of Berenberg Bank, believes the pound has already reached rock bottom and will not go down to parity against the dollar.

“The thing that has led to the partial recovery is the fact that the Government seems to at least be showing some signs of getting its act together by signalling to markets that it will consider what policies it needs to add to Trussonomics to shore up confidence around inflation risks and debt risks.”

If Pickering is right and the Wall Street banks are wrong, perhaps the only way is up from here.