Brexit: Why Sterling Will Keep Sagging

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Fed Minutes

Minutes from last month's US Federal Reserve meeting showed Fed members close to raising rates for the first time since last December. In the end, they held off because stagnating wage increases were holding the inflation rate below its 2% target.

  1. Central bank policies are not working at reviving the economy.
  2. Theoretically, low interest rates should revive consumption (no opportunity cost to spending one's money) and investment (low cost of borrowing).
  3. But practically, this is not happening: precisely because rates are so low and precisely because the population is ageing, pensioners are having go save more and thus spend less.
  4. Besides, central banks cannot do the work of those politicians who refuse to enact structural reforms to get economies going, e.g., in labour markets, competition and education.


Following a 3-day visit to Macau, Premier Li Keqiang has confirmed that Beijing will support the former Portuguese colony in becoming an offshore clearing hub for yuan transactions between Portuguese-speaking countries.

Meanwhile, the PBOC continues to guide the yuan lower. The third consecutive day of weakening has pushed the mid-point of the currency's trading band to a 6-year low.

  1. The PBoC wants the yuan lower in order to "boost exports", although in my most recent book Trade Myths, I argue that the linkage between exchange rates and trade flows does not exist.
  2. Meanwhile, the RMB keeps sagging because of capital flight.
  3. Thus, the PBoC has to go with the flow and allow it to fall. If it tried to halt this, it would have to withdraw the supply of RMB, which would equate to monetary tightening. But against the backdrop of slower growth, the PBoC must try to keep China's Economic Time® from deteriorating further.

British Pound

The sterling trade-weighted index - which is the pound's effective exchange rate, weighted to reflect the UK's trade flows - hit a low of 29.27 on Tuesday. That's the lowest since the index was first compiled in the mid-nineteenth century.

Sterling has depreciated by 21% on a trade-weighted basis since it peaked last November and is down by nearly 16% since the Brexit vote.

To put that into perspective, the decline was almost 30% in 2007/08 during the global financial crisis, and almost 20% in 1992, when the UK crashed out of the Exchange Rate Mechanism.

Meanwhile, the Financial Times (NYSE:FT) is reporting that the UK is facing a Brexit divorce bill of up to €20 billion. This arises from shared financial obligations going back decades, including unpaid budget commitments, pension liabilities and future contractual agreements.

  1. Sterling's problem has to do with the structure of Brexit negotiations.
  2. This structure consists of two parts:

    a. The transitional deal; and

    b. The new trade deal

  3. The transitional deal. According to the FT of 12th October 2016, p. 7, "Under Article 50 of the EU treaties, the EU and UK must settle old bills and agree principles for future relations before the end of a preliminary two-year deadline. Left unsaid is that they will need to manage disruption before the switch to a full trade deal..."
  4. The full trade deal. This could be 3-10 years away.
  5. Moving parts. Both sections of this structure have an awful lot of moving parts, and the devil lies in the detail.
  6. Conclusion. Thus, do NOT expect a "big bang" trade deal, but a long and winding road until both parts have been agree to fully. This will take its toll on the already mushy sterling.

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