British Pound Still Expensive Relative to the Dollar: RBC Capital

"Looked at through the most meaningful measures, it is clear that the current level of GBP is not an impediment to further significant falls" - RBC Capital.

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Despite falling to its lowest levels against the U.S. Dollar since 1985 the Pound is still not cheap, suggesting further losses are likely, according to new research.

RBC Capital Markets says their measures of Sterling's 'real' value suggests it remains near the top of a 30-year range, and note the bottom.

The Pound to Dollar exchange rate (GBP/USD) on Friday fell to 1.1351, its lowest level since 1985.

It is poignant that the decline comes on the 30-year anniversary of Black Wednesday, when Sterling dropped out of the European Exchange Rate Mechanism back in 1992.

"In broad trade-weighted terms, GBP is very close to the level it hit after that collapse," says Adam Cole, Chief Currency Strategist at RBC Capital Markets.

As can be seen below, the GBP TWI puts Sterling right at the bottom of its 30 year range.

Above: GBP's trade-weighted value, in blue, is based on the BoE's GBP TWI).

"That we are at historically low levels already is a frequently-encountered argument against further losses for GBP from here," says Cole.

But, Cole argues it would be unhelpful to look at exchange rates in nominal terms over such long periods (i.e. one would need to adjust for inflation for a better picture).

"There are numerous was of adjusting for relative inflation, but our preferred measure is based on relative labour costs," says Cole. "On this basis, GBP is not at the bottom of its 30 year range, but close to the top".

This is indicated by the black line in the above chart.

Cole says this 'real' measure reflects rapid labour cost growth in the UK relative to its trading partners, which he says has the UK's poor productivity performance to thank.

In the decade leading up to the pandemic, output per hour worked grew at less than half the rate it had averaged in the years leading up to the 2008 global financial crisis. By the end of 2019, it was 20 per cent below the level it would have reached if it had continued on its pre-crisis path.

Above: UK productivity was materially impacted by the 2008 financial crash. Image courtesy of FT.com.

"With the benefit of 30 years of hindsight, GBP was undervalued before its Black Wednesday fall, which had more to do with unsustainable domestic monetary policy than the exchange rate per se," says Cole.

He says at that time the UK’s current account was close to balance, compared to the deficit of 4% of GDP seen in the last four quarters (or 8% of GDP in Q1 alone), again suggesting overvaluation now compared to then.

"Valuation alone is not a reason to be bearish GBP and deviations from competitive fair value can be sustained for long periods without correcting. But looked at through the most meaningful measures, it is clear that the current level of GBP is not an impediment to further significant falls, based on the structural and cyclical factors that we have identified," says Cole.