The value of a nation’s currency in relation to others is governed by 5 main factors:
- The financial health and strength of a nation (Balance of Payments surplus or deficit)
- The interest rate that can be earned by holding a currency
- Whether the nation is a net producer or consumer of raw materials and which they are
- The inflation rate
- Whether the Central Bank is pegging the currency to a fixed level
The dollar
The US dollar is the world’s reserve currency. This means simply most international transactions use dollars. The US accounts for 27% of world trade; 86% is conducted with dollars.
So, when the US Central Bank starts aggressively hiking interest rates, money flows into dollars from other currencies pushing up its value against those other currencies.
This in turn creates a shortage of dollars in free circulation, causing non-dollar assets to be sold which pushes up the relative value of the dollar further.
The dollar is also the currency everyone buys when there’s a shock such as the Russia/Ukraine invasion, it’s the safe haven.
The US are energy independent so are not having to import energy at the current inflated prices.
So that’s why the dollar has been super strong this year.
The pound
The U.K. has a huge inflation problem.
Whilst Covid has caused inflation globally, Brexit has added an extra layer. We will never know how much because of the pandemic effects obscuring it but it’s real and significant.
Additionally, Europe is in deep trouble with energy supplies. Although the U.K. only sourced around 5% of its gas from Russia, it sourced it from places that everyone else is now going since Russia turned off supply, so the effect is the same.
Energy prices are around 500% higher.
The issues and how individual currencies have reacted can be seen in the value in 2022, of the pound against the dollar and the euro:
Pound is down 22% against the dollar year to date
Pound is down 6% against the euro year to date
This underperformance against the euro has only come in the last month.
The budget
The U.K. had the same issues as Europe plus BREXIT complications, but it had more flexibility than Europe so maybe it was a wash.
Then last Friday it cut loose and went full on.
In the face of raging inflation and a pre- announced subsidy of energy bills costing £60 billion, plus the Budget slashed taxes everywhere which is the Government’s income to pay its bills.
It really said, “we are going to print a tonne of money to fund a huge increase in national debt to try to kick start our economy because it’s not growing otherwise”.
It may or may not work but markets hated it.
The U.K. will have raging inflation and ballooning debts.
Answer: Sell the pound and buy dollars.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog, and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.