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Brexit, Black Wednesday and lessons in trading the pound

After the Brexit vote the currency market imposed one of the sharpest devaluations on sterling of the past 50 years, though not as big as Apple might appear to think. Unveiling its new iPhone X this week, the world’s most valuable company said it would go on sale for $999 in the US and £999 in the UK.

The economic consequences of Brexit would have to be pretty extreme for the sterling-dollar rate to hit parity. Indeed, on Friday, the pound sailed through $1.36, its highest level since the days immediately after the EU referendum in June 2016.

Yet sterling devaluations — whether imposed by the market or a government — have come along frequently enough over the last half century to make investors wary of making definitive forecasts for the currency at a time when Britain’s relationship with its largest trading partner is in such flux.

This weekend’s 25th anniversary of Britain’s exit from the European exchange rate mechanism — better known as Black Wednesday — is a particularly useful reminder.

Sterling’s fall following the ERM exit did trigger an export recovery, says Kit Juckes at Société Générale. It plunged nearly 35 per cent against the dollar in the six months after Black Wednesday, driving up export volumes and wiping out the trade deficit. Its decline “sowed the seeds of a better economy”.

But it took years for sterling to recover. “You couldn’t buy sterling until 1995, and the pound only took off in 1997,” explains Mr Juckes. “Even if the economic benefits from devaluation were pretty clear, you still had to wait 18 months to two years before you could pitch your tent on the recovery of sterling.”

Although sterling has risen almost 3 per cent against the dollar and by nearly 4 per cent versus the euro in the last five days, investors will need more than a week of evidence to conclude that sterling can sustain its current levels.

There are three reasons why the pound’s post-Brexit vote drop may not be done. First, it is a hawkish Bank of England rather than any optimism over the outcome of the Brexit negotiations that is pushing the currency higher. And there is plenty of scepticism in the market that the BoE really is at the start of a tightening cycle.

Second, the pound has been ticking higher in recent months partly because of the weakness of the dollar, something that could reverse if an economic stimulus package from Congress and the Trump administration sparks renewed optimism about the US economy.

Third, and perhaps most importantly, sentiment towards sterling is about to be tested by the next chapter in the Brexit negotiations, including an EU summit at the end of next month.

“We have maintained a negative view on sterling throughout this year due to the messy political backdrop and expectations for weaker growth,” say analysts at Goldman Sachs. “In neither case are we ready to abandon those core views.”

That assessment is echoed elsewhere. “The reason why it’s too early to call sterling is we haven’t Brexited yet,” says Jeremy Cook, economist at payments provider World First.

While the UK economy has indeed proved broadly resilient to sterling’s post-Brexit devaluation, with the exception of companies reliant on imports and exports, not much has really changed, he argues.

“Trade terms today are the same as the day before the Brexit vote,” Mr Cook says. “There is a lot more stress for the UK economy to face down over the coming months and years.”

Sterling’s weakness is driving up inflation, squeezing real incomes, but it is debatable how much consumers attribute the rising cost of living directly to the currency decline.

The more direct effect is felt by holidaymakers in the departure lounge and drivers on the forecourt, Mr Cook says, but otherwise sterling’s devaluation “does not have a day-to-day impact on your life”.

Simon Derrick at BNY Mellon wonders why government ministers should worry about sterling’s levels. The stability of the currency was the pre-requisite for entering the ERM and the key determinant for staying there, while the prevailing view was that a stable pound would encourage investors. “But that was the 1980s,” says Mr Derrick.

Sterling’s weakness since Brexit has had negligible impact on people’s pensions or job prospects. “It’s always easier for governments to let sterling take the strain,” Mr Derrick adds.

That is not to belittle the violence of large currency moves of the sort seen in the trading sessions after the Brexit vote. Some of the one-day moves were “particularly extraordinary”, says Deutsche Bank strategist Alan Ruskin. The pound dropped 15 per cent in 10 days. But some of the post-Black Wednesday daily moves were steeper and the drops in 2008 during the financial crisis even more so.

The effect of the Brexit vote did start to break a well-established range in sterling, taking the currency back to levels last seen in the mid 1980s. “It re-awoke some of those concerns of a weaker exchange, but it’s had a very particular political story, so it’s not necessarily the raw underlying economics and a comment on UK competitiveness,” Mr Ruskin says.

Those with longer memories recall how sterling falls are often linked to moments of shock to the UK psyche: Harold Wilson’s 1967 devaluation, the IMF bailout in 1976, Northern Rock in 2007. Brexit is the latest taste of currency devaluation but the pound’s fall in itself does not signal some kind of national failure, argues Mr Juckes.

“We talk about sterling crises, but we have a more grown-up view of currency moves as a relative price. We no longer see sterling as a sign of national virility,” he says.