Three lessons for Americans from the fall of the pound sterling

Three lessons for Americans from the fall of the pound sterling

For now, the Bank of England has restored some calm to global financial markets, which shook a week ago, after Prime Minister Liz Truss’s new UK government and her Conservative Party announced a huge unfunded tax cut. As economists and financial analysts criticized the policy as untimely and irresponsible, the value of the pound plunged, as did the prices of UK government bonds. In finance, however, the weight of money almost always wins out. So when the Bank of England, which can create unlimited amounts of cash, announced on Wednesday that it would buy UK government bonds “on the scale necessary” to “restore orderly market conditions”, investors recovered assets that they treated as radioactive waste. Within hours of trading, yields on British 30-year government bonds, which move inversely to prices, rose from 5.1% to 3.9%, a huge rally. The pound also stabilized. After hitting an all-time low of $1.035 on Monday, it was trading at around $1.11 on Friday afternoon.

Specifically for Americans, yields on US Treasuries, which rose sharply during the selloff of sterling, have also fallen since the Bank of England’s intervention. Given that interest rates across the U.S. economy are tied to Treasury bill rates, this is reassuring news for mortgage seekers, car buyers, and anyone else looking. of a loan. As the Federal Reserve raised the federal funds rate to fight inflation this year, mortgage rates and other borrowing costs rose sharply. The last thing the economy needs is another spike in interest rates unrelated to Fed actions.

This ties in with the first lesson of last week’s events in the UK: the US economy is not immune to international events. Certainly its sheer size – in the second quarter of this year gross domestic product was $25.25 trillion – and the fact that the United States is largely self-sufficient in energy gives us some protection against bad things happening. produce abroad, such as the war in Ukraine. But today’s financial markets are so interconnected that shocks in other parts of the world can quickly spread to Wall Street. Many of the largest US banks, including JPMorgan Chase, Citigroup and Bank of America, have extensive operations in London. If the fall of the pound had turned into a panic selling, accompanied by a massive collapse of the UK bond market, who knows what losses these banks would have suffered?

No wonder US officials have voiced concerns about the UK tax cuts and their potential repercussions. According to Bloomberg News, some US Treasury officials worked through the International Monetary Fund, the Washington-based international lender and watchdog, to pressure Truss’ government to change course. Although the IMF is nominally an independent agency, the United States is its main financial backer and wields great influence over it. In a rare public rebuke from a G-7 country, the IMF issued a statement on Tuesday calling on the UK government to back down. (I contacted the Treasury Department and requested a comment on the Bloomberg story, but none was received.)

The second lesson from last week is that US financial markets, and by extension the US economy, are in a particularly vulnerable position due to the removal of an important safety net: the Federal Reserve’s willingness to rise to the rescue in response to a fall in stock or bond prices, or any other alarming development. This safety mechanism was put into action during the financial crisis of 2008 and then in early 2020, at the start of the coronavirus pandemic. On both occasions, the Fed cut interest rates and also turned on its monetary spigot to buy financial assets that otherwise struggled to find buyers – a policy known as quantitative easing. Right now, however, the Fed is pursuing the opposite policy: raising rates and selling off some of the Treasuries and mortgage bonds it bought earlier.

Should an explosion occur in US financial markets, the Federal Reserve could conceivably follow the lead of the Bank of England starting this week and reverse, at least temporarily. But, after spending the past few months signaling to markets how determined it is to bring inflation down, the Fed would be reluctant to change course. Investors know this, and it adds to market jitters. Unsurprisingly, Fed officials don’t seem to be big fans of Trussonomics. Asked earlier this week whether the announcement of Britain’s tax plan had increased the chances of a global recession, Raphael Bostic, chairman of the Federal Reserve Bank of Atlanta, replied: “That doesn’t help.”

The other lesson of the pound’s troubles is that most Americans don’t realize how lucky they are to have the dollar as their currency. Not only is it accepted in many parts of the world as a means of payment and a store of value, but its status as what economists call the international reserve currency also allows the United States to borrow heavily abroad even that the country goes into more debt. . When other countries introduce expansionary fiscal policies that bear little relation to their future tax revenues, international investors tend to punish them by devaluing their currencies – a lesson that Truss and Kwasi Kwarteng, the British Chancellor of the United Kingdom ‘Exchequer, suddenly come to learn. As the United States has accumulated more than twenty trillion dollars in debt over the past twenty years, foreigners have shaken their heads but have continued to accumulate dollar-denominated assets.

In early 2020, during the early stages of the pandemic, foreign investors – particularly in the Middle East and East Asia – sold Treasuries in large quantities, raising fears that the special status of the dollar not be threatened. Later in 2020, and particularly in 2021, foreign holdings of US government debt rebounded strongly, but in the first half of this year fell again. Unique factors have been cited for these developments and, certainly, the recent strength of the US dollar suggests that there is currently no lack of appetite for dollar-denominated assets. But the pound’s setbacks should remind us that things can change.

In the 19th and early 20th centuries, the pound sterling was the international reserve currency. Then the dollar replaced it. Fortunately for Americans, no suitable replacement for the dollar has been found: the greenback still rules. This situation may persist, but it will not last forever. If that ever changes, watch out. ♦

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