Pound falls to lowest level since 1985 as UK economic pain deepens

The British pound fell to its lowest level against the US dollar since 1985, reflecting the dire financial condition of the British economy. Investors are bracing for sterling to weaken further to a nadir not seen in more than two centuries of trading across the Atlantic.

The pound was down 0.3 percent in early Asian trade at $1.1475, according to FactSet. That’s the lowest since 1985. Sterling’s slide is partly a side effect of the US dollar’s relentless rally, which has driven both the euro and the Japanese yen to multi-decade lows in recent days.

But the problems are also domestic. The UK is facing an energy crisis that threatens to leave many households unable to pay their bills this winter. Uncertainty about both the economic policies of the next UK prime minister and the Bank of England’s ability to control excessively high inflation are adding to the pound’s weakness.

“The financial challenges facing the UK economy are probably as great as anything we’ve seen in living memory,” said Mark Dowding, chief investment officer at BlueBay Asset Management.

Goldman Sachs has warned that UK inflation could top 22% next year amid spiraling energy costs, one of its starkest predictions yet. The bank estimates that the UK economy would shrink by 3.4% in this scenario.

Mr Dowding believes the pound could fall to parity, or a 1-to-1 exchange rate, with the US dollar next year. The pound has never been worth less than $1 in the pair’s 200-year history—though it came close in 1985 when sterling fell to $1.05, before the world’s biggest economies joined forces to weaken the U.S. dollar below what is called Plaza Accord.

“There’s a really bleak path where you end up with the UK almost having to go back to [International Monetary Fund] for a bailout as a quasi-emerging market crisis,” Mr Dowding said. In 1976, a pound crisis forced the UK to seek a $3.9 billion loan from the IMF. “This is the worst of the scenarios,” he said.

The British pound was once the world’s preeminent currency. But the value of the pound has been in steady decline over the past century, coinciding with the erosion of its position as the main currency in world trade and central bank reserves. The 2016 Brexit vote delivered another heavy blow, leading to striking comparisons between the pound and riskier emerging market currencies.

More cautious investors and analysts have dismissed the comparison as overblown, but some are beginning to recognize a growing list of similarities.

Adam Cole, head of currency strategist at RBC Capital Markets, is concerned that the typically positive relationship between UK interest rate expectations and the pound appears to have broken down.

In normal times, higher interest rates make holding a currency more attractive as investors are rewarded with a higher return. But of late, yields and the pound have moved in the opposite direction.

The pound fell 4.6% against the dollar in August, its worst month since October 2016.

Meanwhile, the yield on the UK 10-year government bond rose to 2.880% from 1.808%, the biggest monthly rise since 1990.

“Periods where interest rate expectations rise and the currency falls is something we expect to see in emerging rather than developed markets,” Mr Cole said.

Mr Cole said the collapse in the correlation reflected doubts about whether the Bank of England’s plans to raise interest rates would ultimately succeed in controlling inflation.

The pound is also vulnerable to ever-widening deficits that have left the country relying on what former Bank of England governor Mark Carney described as “the kindness of foreigners,” or foreign investors, to fill funding gaps.

The UK’s current account deficit, a broad measure of trade flows and income, jumped to a record 8.3% of gross domestic product in the first quarter, partly due to the rising cost of fuel imports.

For the most part, foreign investors were happy to play this role, buying British companies, government debt, property and shares. One benefit of a weaker pound is that it makes assets look cheaper to foreign investors, as well as making UK exports more competitive abroad.

“The UK has always lived above its means,” said Guillaume Paillat, multi-asset portfolio manager at Aviva Investors..

Resilient demand from foreign investors for UK stocks is “the only way the UK has been able to close this gap”, he said.

How have China, Mexico and Greece dealt with inflation and where does the US fit in? WSJ’s Dion Rabouin explains.

Foreign investors sold 16.5 billion pounds of UK government bonds in July, according to data from ING and the Bank of England, the most since July 2018. Meanwhile, international investors have trimmed holdings in shares of United Kingdom. A Bank of America survey of global fund managers showed 15% were underweight UK stocks in August, compared with 4% in July.

The Conservative Party leadership contest is set to conclude on Monday, with Foreign Secretary Liz Truss seen as a possible successor to Boris Johnson as prime minister. Ms Truss has pledged to cut taxes but has not detailed her plans to combat rising inflation and energy prices. An increase in the government’s borrowing needs could further test investors’ willingness to finance it.

“If you do get easier fiscal policy—more likely tax cuts—that means more imbalances,” Mr. Paillat said.

Write to Chelsey Dulaney at chelsey.dulaney@wsj.com

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