The pound plunged to an all-time low against the dollar earlier today after the Chancellor of the Exchequer, Kwasi Kwarteng, hinted that more tax cuts were to come in the wake of last week’s seismic ‘fiscal event’ that was a Budget in everything but name.
Following overnight trading in Asia, sterling tumbled to $1.0327 on Monday morning, 26 September, its lowest value against the ‘greenback’ since decimalisation was introduced to the UK in 1971.
The pound later clawed back some ground to trade at about $1.08. Despite this respite, sterling has generally been on a downward trajectory in recent weeks against the US currency, with today’s news exacerbating fears the pound could even slump to dollar parity by the end of this year.
Most people only concern themselves with exchange rates as they’re about to head off abroad on holiday. But changes to a currency’s value have wider ramifications beyond the price you’ll pay overseas for a cocktail at a beachside bar.
Here’s a look at what influences a currency’s value, who benefits from a strong or weak pound, and what the current state of sterling means for your savings and investments.
Exchange rates
Some of the factors that influence a currency’s value include:
- Inflation. Countries with relatively low inflation tend to have stronger currencies. This is because low inflation gives a currency greater purchasing power.
- Interest rates. High interest rates boost returns on assets such as bonds. This can attract foreign capital, bolstering the local currency.
- Economic/political stability. A stable country with a solid, growing economy will attract foreign investment. This helps to increase the demand and value of its currency.
Other relevant economic indicators include a country’s balance of payments, as well as its economic policies and attitude towards intervention in currency markets.
Why is the pound so weak?
The value of the pound against the dollar has been on a downward path for much of this year. Several factors, including soaring energy prices and the war in Ukraine, mean the UK’s inflation figure has shot up during 2022, prompting ever-increasing fears that the nation’s economy will slide into recession.
In recent days, there have also been major concerns that the tax cuts and increases to public spending announced by the newly-formed Conservative government, under prime minister Liz Truss, could exacerbate price pressures. The result of this has been to make the markets extremely jittery.
Alice Haine, personal finance analyst at Bestinvest, says: “A plummeting pound is often considered a gauge of the outlook for the UK economy, with the dramatic declines in sterling seen since the Chancellor unveiled his tax-cutting mini-Budget on Friday indicating just how much the markets were spooked by the Government’s fiscal plan.”
In contrast – and despite facing similar economic conditions and inflationary headwinds – the US dollar is relatively attractive because it is by far the largest reserve currency for the global economy. This means it is the main currency that countries hold to weather economic shocks, pay for imports and service debts.
By dint of being the world’s reserve currency, the dollar is also regarded as a safe haven in uncertain economic times.
Brian Byrnes, head of personal finance at Moneybox, says: “The US dollar has been strong across the board this year, strengthening to parity with the euro in recent months. Against sterling, it has also been gradually strengthening over the course of 2022, but the pace has picked up in the last few days since the government’s recent ‘mini-Budget’.
“Currency markets seem to have little faith in Kwasi Kwarteng’s measures to raise growth prospects and have been selling off the pound in response. Meanwhile, the US Federal Reserve has raised interest rates faster than most of its global counterparts, creating strong demand for the dollar.
“Parity between the pound and the dollar was unthinkable not long ago, and now it seems not far away.”
What does a weak pound mean for UK consumers?
For consumers, a falling pound means their money won’t stretch as far when they pay for goods and services imported from overseas, including oil.
Bestinvest’s Alice Haine says: “As with most major commodities, oil is priced in dollars which means filling up your car will be more expensive, even though the price of oil is back to the same level it was at the start of the Russia-Ukraine conflict. The price consumers pay in the UK is still relatively high because of weakness in the pound.
“With almost half of the food that Britons consume imported, your supermarket shop could also be more expensive if your trolley is filled with overseas produce. But with most food imports coming from Europe, where the euro is also down sharply against the dollar, the effect might not be as dramatic.”
That said, rising oil and food prices could put further pressure on inflation at a time when consumers were hoping skyrocketing price rises were coming to an end. The inflation rate dipped slightly to 9.9% in the year to August 2022 from 10.1% the previous month. A weak pound could easily reverse this recent direction of travel.
What does a weak pound mean for travellers?
Rob Burgeman, senior investment manager at wealth manager Brewin Dolphin, says: “A weak pound is something many of us have got used to over our lifetimes, but even by these historic standards, the recent plunge has been spectacular.
“It is important to understand that, while sterling has fallen to a level against the US dollar not seen for fifty years, we have been lower against the euro in the not-too-distant past, hitting a low of €1.0448 at the height of the financial crisis in 2008.”
“We can probably still afford a paella in Valencia or a gelato in Rome. But a trip to the US now looks like more of a stretch, with the pound having fallen by more than 20% against the dollar this year and almost 25% from its peak in the middle of last year.”
Ms Haine adds: “The falling pound is not just bad news for travellers heading to the US, but also to those countries whose currencies are pegged to the dollar, such as the Gulf states.”
How does a weak pound affect companies?
Sarah Coles, senior personal finance analyst at Hargreaves Lansdown, says: “The impact on your investments will depend on what you hold and where those companies make their money”
“Overall, the UK stock market looks likely to head higher, because most large companies listed in London actually earn the bulk of their revenues and profits overseas. Those values will be worth more in sterling terms as a result of the slump in the pound.”
Victoria Scholar, head of investment at interactive investor, says: “The FTSE 100 is holding up well as there tends to be an inverse correlation between the performance of the pound and the UK’s leading stock market index. This is because weakness in sterling tends to benefit the big UK exporters listed in London such as Diageo, Coca-Cola or GSK.
“The weakness in sterling tends to make UK exports more competitive on international markets. However, a weak currency can exacerbate inflation as it makes our imports more expensive, which could add to the cost-of-living crisis by making goods and services less affordable.
“Also, for businesses, importing from abroad has become more expensive, driving up their costs and squeezing margins.”.
Ms Coles adds: “Retailers and other businesses who buy goods from overseas can try to pass the higher cost of imported goods on to consumers, or they can try to cut their operating costs, but the speed with which sterling has fallen is going to prove a huge challenge.”
How does a weak pound affect savings and investments?
Bestinvest’s Alice Haine warns that, because of sterling’s fall against the dollar, would-be UK-based investors now might not be the best time to invest reduced pound in US shares or global equity funds.
But she says investors can take heart from the better news that the strong dollar has masked losses that have occurred on both the US and global stock markets this year: “While the influential S&P 500 index of US shares is down by 22.5% over the year-to-date, the currency effect on UK-based investors from owning US shares has softened losses in pounds to a loss of just 3.7%.
“As a result, DIY investors might want to consider UK-listed companies, particularly large ones, which earn most of their revenue in dollars as this will flatter their profits when they are converted into sterling.”
Brewin Dolphin’s Rob Burgeman says: “For those investors based in the UK, the weakness of the pound has provided some shelter from extremely stormy stock markets. The Dow Jones Industrial Index is down 18.57% so far in 2022 in dollar terms, but in pound terms is up 2.94%.
“This international diversification can greatly help to smooth out returns for UK investors. A low exchange rate, too, can encourage tourism and business investment in the UK as the costs of production are so much lower than their US equivalents. Savers, too, might finally have something to smile about as cash deposits are finally beginning to pick up, albeit still well below the rate of inflation.”
This is because the Bank of England has put its official Bank rate on an upward trajectory, in part to defend the value of sterling by making it more attractive to currency traders.
Banks and building societies set their rates with reference to the Bank rate, so we should see gradual improvements in savers’ earnings as a result.
