Margaret Thatcher always used to say that "you can't buck the markets." Having in 1990 been dragged very much against her will into joining the exchange rate mechanism of the European Monetary System (in which other EU currencies traded in a fixed band around the deutsche mark in what was intended as a precursor to the euro), she appeared to gain vindication 30 years ago today, when the UK government abandoned its attempt to keep the pound within the mechanism and let it float — which in practice meant that it let the currency collapse.
The events of "Black Wednesday" were a classic example of how economic actors can inadvertently display their weakness when they try to show strength. The pound had been overvalued when it entered the mechanism. Then the mark strengthened still further after the Federal Reserve in the US started to cut rates in an attempt to stimulate the economy. That briefly pushed the pound above $2.00, an infeasible level. The chart shows what happened next:
Hedge funds, led by George Soros, who would become a household name as a result, saw that such a high level for the pound could not be defended and prepared to place big negative bets against sterling. Early on Black Wednesday, the Bank of England (not independent of the government at that point) announced that it was raising rates by two whole percentage points, from 10% to 12%. With most British homeowners on variable-rate mortgages, this meant that their monthly borrowing costs had just leapt by 20%. Still, everyone kept selling the pound. By lunchtime, there was a fresh announcement; the lending rate was going up to 15%.
This extraordinarily aggressive step was directly counterproductive. It meant that everyone's mortgage payments would go up by 50%, which traders (particularly Soros) knew was untenable. Everyone kept selling the pound, with only the Bank of England itself around as a buyer. After the market closed, the chancellor, Norman Lamont, announced on a street pavement that Britain was leaving the exchange rate mechanism. Next morning, the BOE cut rates all the way down to 9%, and the government embarked on a new strategy based on a weak currency. It strengthened the economy nicely, but not the political fortunes of the Conservative Party, by then led by John Major; its reputation for fiscal competence would take a generation to recover. One of the many important lessons from the incident, which was to be reinforced in numerous emerging markets over the decade that followed, is that governments can't peg a currency above a level that the market will accept.
It doesn't have to be the government that takes the blame. In 1985, the pound tanked after the Fed raised the fed funds rate to 11.75% late in the previous year. It led to a speculative pile-on that took the pound as close as it has ever been to parity. And the biggest daily fall by far for the pound came on the night of the Brexit referendum in 2016. Black Wednesday saw the first ever fall of more than 4%; the British electorate managed to make it fall by 8%:
What lessons for today? Any intervention in foreign exchange markets must be credible to have any chance of working. And when the Fed takes a course that is out of sync with the rest of the world, stresses increase on the rest of the foreign exchange architecture.
That's unfortunate because US bond yields are in an upswing again. As of late Thursday trading, 10-year real yields (which offer inflation compensation) had topped 1%. This landmark was last reached for a few weeks in late 2018, and helped to precipitate a stock selloff and a "pivot" toward easy money by the Fed. That seems very, very unlikely in the immediate future. Before 2018, real yields had been below 1% uninterruptedly for seven years:
In the six months since the invasion of Ukraine, 10-year real yields have surged by more than two full percentage points. This is as big a financial shock as any since the global crisis year of 2008. And the problem is that this brings more money into the dollar, and puts more pressure on everyone else. These charts from George Saravelos, who heads foreign exchange at Deutsche Bank AG in London, show that "safe-haven" flows and cash hoarding are strengthening the dollar:
If anyone wants to try making a big contrarian bet based on fundamentals, they have a problem because those fundamentals have never been so ambiguous. Saravelos cites the following extraordinary example. Real effective exchange rates, taking into account the different inflation rates in the two currencies, can be based on either producer or consumer prices. This doesn't usually make much difference. Now, the differential impact of the energy crisis has left the euro fairly priced based on producer prices (which are shooting higher), but massively undervalued on the basis of consumer prices. What to do?
These could be difficult times to intervene, then. If anyone should be tempted to try, it might be the Bank of Japan. The country continues to have far lower inflation than anyone else, and this should lead its currency to appreciate over time. Thus the extent of the devaluation it has suffered on a real effective broad rate is awe-inspiring. This is how Citigroup's broad measure has moved this century:
The last big wave down came with the advent of "Abenomics," after the late Shinzo Abe became prime minister for the second time 10 years ago and the government wanted a big boost to Japan's competitiveness. It was welcome. This most-recent fall, as the BOJ stays obdurately dovish and points out that Japan's inflation is still low, is not. That leads to speculation about intervention from the Ministry of Finance to strengthen the yen. The problem with this, as this chart from Citi shows, is that almost all recent attempts at intervention have backfired. The ministry sold yen (to make the currency go down), and instead it went up:
The bruised British officials from 30 years ago would probably advise the Japanese to save their money and not attempt to buck the market. When the Fed is out of sync with the rest of the world, and the global imbalances are as deep as they are now, it's best for everyone else to maintain what the British would call a stiff upper lip.
That leads to the question of exactly where the global economy is heading and whether the imbalances are here to stay. And unfortunately, the latest data from the team at Barclays shows that imbalances look set to intensify:
A (Bad) Lookback
It hasn't been the best few months for the global economy, thanks to at least three shocks: the energy crisis in Europe, the ongoing pandemic lockdowns in China, and the decision by central banks worldwide to tighten monetary policies to curb surging prices of goods and services. That triple whammy, enumerated in a recent Barclays note, sets the stage for a "synchronous global slowdown."
That's mainly because there is no sign of central banks letting up. Barclays analysts Ajay Rajadhyaksha and Amrut Nashikkar don't expect the Fed and ECB to show any signs of hitting the brakes for the rest of the year.
The reason for such hawkishness is the multi-decade surge in inflation on both sides of the Atlantic massively exacerbated by the energy shock caused by the invasion of Ukraine. Prewar, Russia had provided roughly a quarter of Europe's energy (gas and oil). A few months ago, many analysts assumed the use of natural gas exports as a bargaining tool would have ceased in time for normal supplies by winter, when Europe's gas needs are greatest. Instead, in mid-September, Russia is still amping up the pressure by cutting off supply, claiming technical reasons.
On the other side of the world, China, normally considered the largest contributor to global growth, saw a very weak second quarter as lockdowns in major cities like Shanghai continue. Even as rules have relaxed recently, such restrictions have significantly hurt economic activity. The nation's real estate sector continues to falter in the third quarter.
"All in all, the world economy seems headed for a very sharp slowdown," they wrote in a note Thursday — a view echoed by the logistics group FedEx. "We expect inflation worldwide to slow as activity weakens and base effects kick in."
For now, inflation has driven spectacular corrections for bonds — although it's noticeable that the US is relatively unscathed. The graph below shows the performance of the Bloomberg indexes for corporate and government bonds in the US, eurozone and emerging markets. All suffered a dramatic drop during the the first Covid-19 lockdown, and all rebounded. This year has been terrible for fixed income, but Europe's bonds are now seeing a far sharper selloff than in the US:
Equity indexes aren't faring any better, slumping anywhere from 15% to 25% across the developed world. Even emerging market stocks have joined the downturn, shedding over a quarter of their value this year. Few asset allocation choices prove attractive amid this environment, pushing investors to look for "the least dirty shirt in the laundry."
For the Barclays analysts, whether considering equities or debt, the cleanest shirts are in the US. "The one standout for us is not an asset, but a geography. Specifically, the US is in better shape than other major economies."
Its growth outlook, while poor, is better than for Europe and China (adjusted for the DM-EM difference). And alone among Western economies, despite the upside surprise in August, we believe that US inflation could moderate in 2023. We expect US consumer prices to rise at sub-3% next year, a big gap to the 6.3% that we expect in Europe or the 5.5% we see in the UK. Moreover, the Fed is further along in hikes than either the ECB or the BoE. The US has a better chance than other developed economies of escaping without a significant recession, so USD assets still look attractive in a relative sense.
If things work out that way, there should be some support for Treasury bonds next year (although that changes if the Fed has to be even more aggressive). In equities, they see more downside despite the recent selloff. Valuations are more reasonable now, yes, but there is room for more compression in the event that inflation keep surprising on the upside or growth disappoints. Like most analysts, they think earnings continue to pose the biggest risk, as estimates remain far too optimistic.
Some recommendations from them: own some cash, the first time in a while they're advising investors to do so, and wait for "more attractive entry points in risk assets." And perhaps most importantly, shelter in the US and brace for dollar strength.
The Death of Knut
Be careful with your analogies. Yesterday, I wrote about Knut, the baby polar bear who was rejected by his mother at the Berlin Zoo soon after he was born in 2006. The zoo decided to try to nurture him to health, even though other zoo managers said that it would be better to let him die. Jean Boivin, once deputy head of the Bank of Canada and now at BlackRock, used this as an analogy for central bankers. By pressing ahead with higher interest rates to slay inflation, and in the process inflicting economic pain and recession, he suggested that central bankers were playing the role of those who said Knut should be left to die.
Now, a couple of readers have written in to point out that the analogy might well support the argument for tough monetary policy, rather than the reverse. Raja Visweswaran of Deutsche Bank AG in London writes as follows:
The story of Knut wasn't a happy one — even though the Zoo rescued the cub, he died at barely 4 years of a suspected congenital condition that "proved" post-facto that his mum had been right to reject him. So too perhaps the great and the good central bankers will be making the right decision to "kill" the decrepit, over-leveraged, vastly imbalanced global economy as it stands today.
Randall McCuen, chief executive officer of MAC Wealth Management, ties the sad story of Knut with Arthur Burns, the Federal Reserve chairman who has largely taken the blame for the inflation of the 1970s:
Some megaphone-holders will argue that, hey, inflation is not unanchored and is coming down and transitory has finally arrived. And isn't the Fed charged with full employment too? Arthur Burns supporters will cheer this on to remove his name as the sole title holder.
Arthur Burns was there from 1970-78. Four years into his term, the end of 1974, was when the worst hit for markets. Interestingly enough this turned out to be Knut's worst point, too. I expect the same this time, just as the article suggests that a debate will occur about what is the least bad outcome for the least dirty shirt economy in the laundry. This next decade surely is writing the story itself as a sequel to the 70s.
If it wasn't evident already, the moral and political dilemmas that lie ahead for central banks promise to be as intractable as the economic challenges.
Asked after Black Wednesday if he had any regrets, Norman Lamont, the chancellor of the time, said "Je ne regrette rien." He was relieved of his job soon after, though Edith Piaf's anthem is still a masterpiece of bravado and hope. Lamont's youthful assistant gaining his first experience in politics, the future prime minister David Cameron, subsequently said that his favorite song was Tangled Up In Blue by Bob Dylan, which also seems appropriate given his entanglement in Britain's serial ruptures with the European Union. Black Wednesday came as The Shamen's Ebeneezer Goode (featuring a Frankie Howerd sample and rendered on the soccer terraces as "The Referees Are Good") replaced Snap's Rhythm Is A Dancer as the number one; both are classics of the rave culture, then at its peak in the UK. So if all else fails, you could always go and dance all night in a field with thousands of others.
John Authers is a senior editor at Bloomberg.
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.