How low can sterling go?

Britain's household finances are in a dire state and the UK economy is running a huge deficit. With even the Bank of England unlikely to spend much effort supporting sterling, it could be in for a very long slide indeed.

Britain is facing recession. And it's not going to be short and sharp it's going to be long and unpleasant.

That's nothing most of us didn't already know. And yet, the pound has crashed in the last couple of days after one man admitted that hard times were here to stay.

Why does this one man make such a difference? That'll be because it's Mervyn King, Governor of the Bank of England, and the man with his finger on the UK's interest rate button. As Geoff Dicks at the Royal Bank of Scotland tells the FT, Mr King and colleagues have "450 basis points and they'll use the lot if they have to."

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I've got a lot of time for Mervyn King. Almost alone among Britain's financial authority figures, he was warning of the dangers of the housing bubble and mass indebtedness for years before the bubble burst. Meanwhile, our Prime Minister and his fellow politicians were happily declaring that soaring house prices were evidence of strong economic growth, rather than the unsustainable mania which they've turned out to be.

But of course, Mr King and the Monetary Policy Committee did play a big role in pumping up that market, with overly low interest rates. And now that the bubble has burst, everybody's worrying about deflation, not inflation. And rightly or wrongly that's something that everyone wants to prevent.

So the MPC is now in rate-slashing mode. Rates were cut by half a point at the start of this month, and in the minutes of that meeting, Mr King said "the balance of risks to inflation in the medium-term has shifted decisively to the downside." So it looks like there are plenty more cuts to come.

Hence the collapse in the pound. Sterling has fallen by more than 6% against the dollar since Monday, its worst showing since it was ejected from the European Exchange Rate Mechanism in 1992. And all the signs point to the pound collapsing further. It's not as if many other countries have particularly healthy economic backdrops, but remember that currencies are all about values in relation to one another. For example, the US might be in recession too, but it's the world's biggest economy, and the dollar is the world's reserve currency. That still makes it a safe haven in many people's eyes.

It's been a long time since sterling was the world's reserve currency. And in almost all respects, the UK economy looks a worse bet than even America's. Our housing crash has further to go. Our interest rates have further to fall. Our recession has started later, and so is likely to continue for longer.

But it's not just the grim economic prospects. As Edmund Conway points out in The Telegraph, Mr King also said that he's worried that overseas investors will no longer act as a prop for Britain's economy and currency. "For several years, the UK banking sector has been relying extensively on external capital flows, principally short-term wholesale funding, to finance its lending activities." In other words, your mortgage has been funded by money from abroad.

"Those external inflows have fallen sharply a mild form of the reversal of capital inflows experienced by a number of emerging market economies in the 1990s." As Conway points out, comparing Britain's outflow of cash to the Asian financial crisis seems "pretty dramatic", more so when it comes from the governor of our central bank.

"Unless they are replaced by other forms of external finance, the adjustments in the trade deficit and exchange rate will need to be larger and faster than would otherwise have occurred, implying a larger rise in domestic saving and weaker domestic spending in the short run." In other words, if foreign investors are no longer willing to fund our spending, we'll just have to save more, like it or not. And if Gordon Brown spends too much money on his "Keynesian stimulus" we could see the pound collapse even further and faster.

That's all bad news. But the fact that Mr King is willing to express it so publicly, also suggests that the Bank of England has no intention of acting to support the currency it's almost warning of further weakness. So Kamal Sharma at JP Morgan tells the FT: "The path of least resistance remains to sell the pound over the coming months, particularly with a central bank content to see further depreciation."

Capital Economics reckon that the pound will fall to $1.50 by the start of next year. "Sterling has long been particularly vulnerable because the imbalances in the UK economy notably the dire state of household finances and the large external deficit are just as severe as those in the US." We've been suggesting that sterling would hit the rocks for some time now, most recently in July (see: Why the party's over for the bloated pound). It doesn't seem likely to bottom out any time soon.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.