An alert just went off in my calendar. “Start looking to short the British pound”, it says. Why would one short strength? Sterling has been very strong over the past few months (mainly due to higher interest rates).
You wouldn’t know it to listen to many financial commentators, who so often seem consumed with national self-loathing, but against a basket of major foreign currencies, the pound is actually flirting with six-year highs. It has a bit further to go against the euro and the US dollar; we tend to think of the pound-dollar rate, aka cable, as the defining measure.
Charlie Morris of asset manager ByteTree argues that the pound has become a carry trade (whereby you borrow at a low-interest rate in one currency and invest in another currency with a higher rate of return).We appear to be in an equities bull market, and the pound, as the currency of a nation geared to finance, tends to be strong when financial assets are strong. During times of financial crisis, it is much weaker.
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Whatever the explanation for the recent strength of the pound, I set the alert some three or four years ago – before the strength kicked in. What on earth was I thinking? It’s based on a cycle I’ve identified. As far as I know, I’m the first to observe this cycle, so, with Brand Frisby in mind, I’ve named it after myself: Frisby’s Flux – the eight-year cycle in the pound.
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Before I explain the cycle, let me issue a disclaimer. As I explained last week, it’s easy to look back at the past, find some arbitrary pattern and declare it a cycle. Real life in real time is often a very different matter. Nevertheless, cycles can help frame where we are in the grand scheme of things.
Eight-year cycle in the British pound
My observation is that every eight years, the pound seems to crash. We start in 1976, the year we needed a loan from the International Monetary Fund. At one stage, inflation reached 24%. The Labour government borrowed $3.9bn, at the time the largest loan ever requested. From high to low, sterling lost around 40%, reaching $1.60. But it recovered. By the early 1980s sterling was back above $2.40.
Then came the next bear phase, in which the pound would drop by more than 55% and reach a record low against the dollar: $1.04. This was the era of the Falklands War and then the miners’ strike. The low came shortly after 1984 became 1985.
On the other side of the trade, the US dollar was showing extraordinary strength – so much so that France, Germany, Japan, the US and the UK eventually colluded to depreciate it.
This was the Plaza Accord of 1985. Again sterling would recover – this time to $2. Eight years on, in 1992, sterling hit another significant low. This was Black Wednesday, when the Bank of England took the UK out of the European Exchange Rate Mechanism (ERM). It fell from $2 to $1.40 – a 30% loss. The killing that George Soros made selling the pound sealed his reputation.
Eight years later, around 2000, as the dotcom bubble collapsed, the pound lost a fifth of its value. (What did I say about the pound being geared to finance?) But again it rebounded. By 2007 it was above $2.10. Can you imagine? The pound above two dollars only 16 years ago.
Then we got the financial crisis of 2008 and, yes, the pound lost 35%, hitting a low of $1.36. The next low came in 2016 with the infamous Flash Crash, shortly after Theresa May’s speech at the Conservative Party Conference. Having been above $1.70 at one point earlier in this cycle, it hit a low of $1.14. The overall drop from high to low was 35%.
The subsequent bull market was probably the limpest in living memory. The 2016 low was retested in the Covid panic of 2020, but then we had a good rally to $1.42 by mid-2021. After that, with so much political upheaval, the pound turned down. When the Bank of England broadcast that it would be selling the UK gilts it had printed the money to buy during quantitative easing (QE), and chancellor Kwasi Kwarteng then gave us his low-tax budget, panic gripped the markets and the pound hit an intraday low of a $1.04 (the same low it hit in 1985). Since then we have had quite some rally.
What’s next for the British pound?
Did the eight-year cycle low come early? Was that it in 2022, or can we expect it some time in 2024? When I first wrote about Frisby’s Flux in 2017, I suggested that we should be looking for a high some time in 2022-2023, as an opportunity to go short. That is why I got that notification in my calendar. This current rally might be providing us with just one such opportunity. The question is: how long will it go on?
On a long-term basis, the pound at $1.28 is not exactly hugely overvalued. The Economist’s Big Mac Index gauges whether currencies are overvalued or undervalued by calculating what exchange rates would be if the price of a Big Mac were the same everywhere – if purchasing power were equal everywhere, in other words. The Big Mac gauge suggests we are not far off fair value. As I say, cycles are easy to identify in the rear-view mirror. They are much harder to trade in real time.
Perhaps the trigger will be yet more dysfunctional politics. Perhaps the Bank of England will fall even further behind the inflation curve and rates will spike, triggering some kind of crisis such as we saw in the lead up to 1992. Maybe equities more generally turn bearish. We can only guess what the trigger might be. But Frisby’s Flux, whatever it is worth, and that might be very little, is suggesting there might soon be an opportunity to go short the pound, looking for an eventual low in 2024.
