In Short: The potential perils of the pound's fall

10-10-2016

The British pound has been under immense selling pressure after the U.K. voted to end its membership in the European Union in June. Year-to-date, the pound easily ranks among the developed world’s poorest performing currencies, down 16% against the dollar. Until recently, the Bank of England (BOE) actually welcomed the weakness as beneficial to its accommodative monetary policy. Considering the country’s formidable 6% current account deficit and tepid inflation, it helped to counterbalance many of the negative side-effects of Brexit.

But the pound selling accelerated last week after Prime Minister Theresa May shortened the timeline to leave the eurozone’s single market. This furthered devalued the currency and, at one point, triggered a 6% decline in a matter of seconds—a “flash crash” as it is now coined. Although the pound immediately reversed most of that loss in another blink of an eye, the fact that such a whirlwind pricing event even happened unleashed a host of questions regarding the pound’s status in the financial world. After all, a reserve currency is not supposed to trade like a penny stock.

In life, it is often said that “the journey is more important than the destination.” It may seem strange, but financial markets have a similar guiding principle. The velocity of transactions and trading is just as important as the actual target. While it is natural for risk premiums of all types to rebalance to both cyclical and secular economic changes, how they do so is critical to many, from the common investor to central bankers. A rapid decline in the pound could ultimately present a material threat to the British economy and the BOE. If left unchecked, it could trigger massive capital repatriation from the U.K. as investors lose confidence in its growth and in the pound itself.