U.S. Markets closed

Pound-dollar parity? A look at the 200-year relationship of the currencies

Jonathan Jones
The pound has fallen to $1.24 - Copyright 2016 The Associated Press. All rights reserved.

Fear that a no-deal Brexit could cause the pound to fall to parity against the dollar for the first time in its history have been renewed this week. The prospect rose when, in a television debate, both candidates in the Conservative leadership race – Boris Johnson and Jeremy Hunt – refused to rule out the scenario.

In response, the pound has fallen to a two-year low of $1.24 and is 17pc lower than before the referendum in June 2016.

Many have suggested the British currency could tumble as low as $1.00-$1.10 if the country crashes out of the EU at the end of October.

It would represent a further 19pc fall for the currency, rivaling the 25pc drop on Black Wednesday in 1992, when the UK was forced to withdraw from the European exchange-rate mechanism.

But the recent movements are only the tail end of a more than 200-year relationship between the two currencies.

For most of the 1800s until the start of the First World War, every £1 was worth just under $5. The Napoleonic wars, which weakened the pound, was one exceptional period; as was the US Civil War, which saw the pound temporarily spiking up to $10.

Over much of this period the "gold standard" was in force, which required nations to back the value of their banknotes with the equivalent in gold, establishing stability in exchange rates.

At the outbreak of the First World War, the gold standard was suspended, and the financial burden of the war saw sterling sink to $3.66.

James Carthew, head of research at QuotedData, the analyst, and a former fund manager at M&G, explained: "The expense of the First World War took its toll on sterling as the currency was allowed to float, but Britain returned to the gold standard in 1925. The advent of the Great Depression in 1931 meant that the gold standard had to be abandoned."

Governments however still viewed fixed exchange rates as desirable, and so in 1940 the pound was pegged to the dollar at a fixed rate of $4.03. This deal became part of the Bretton Woods agreement that was signed in 1944, which governed financial relations between 44 countries for much of the mid 20th century.

The aim of Bretton Woods - which also saw the creation of the World Bank and the International Monetary Fund - was to do away with "competitive devaluation" and the strain of maintaining fixed exchange rates. All currencies became linked to the dollar, and the dollar itself was linked to gold.

For the pound, the cost of the Second World War meant the fixed rate of $4.03 was unsustainable, and the currency was devalued to $2.80 in 1949.

This was maintained until 1971, when the Bretton Woods system disintegrated - largely due to its inflexibility - and the pound became the freely floating currency that it remains today.

Mr Carthew said: "In the early years of the graph, the UK was sucking in wealth from all its colonies, and this buoyed sterling. In some ways the weakening pound marked the shift as the US took up the mantle of the world's largest economy from Britain.

"For long periods, while the Government sought to control the exchange rate, sterling was overvalued and this would have hurt UK exporters and would have played a part in the collapse of the UK manufacturing industry."

Major change in the pound-dollar relationship

From the beginning of the free-floating pound until the mid 1980s, the exchange rate in nominal terms trended downwards - since then it has been between $1.30 and $2. But the picture is different if the inflation adjusted rate change is looked at.

The chart above is taken from research conducted by Prof Elroy Dimson, Prof Paul Marsh and Dr Mike Staunton for a report published by Swiss investment bank Credit Suisse.

It shows the change in both the real and nominal pound-dollar exchange rate since 1900, rebased to one at the start of the data.

Far from the pound being on a downward trend, since the end of the Second World War the rate has remained remarkably level in real terms, albeit with significant volatility through the major inflation peaks of the late 1970s and early 1980s.

Elroy Dimson, emeritus professor of finance at the London Business School, said: "Over the long term, the pound has been weak against the dollar, depreciating over the past 116 years by an annualised 1pc - that is largely attributable to Britain's higher inflation rate, which had the effect of debasing the purchasing power of the pound.

"If you look at the real (inflation adjusted) exchange rate of the pound against the dollar, it has weakened over the past 116 years by a minuscule 0.22pc per year."

David Blake, professor of pension economics at Cass Business School, said: "The chart shows precisely what you would expect - that the real exchange rate shows no real trend from when sterling started floating against the dollar following the collapse of the Bretton Woods agreements.

"This is because the nominal exchange rate will adjust to reflect differences in inflation rates in order to maintain 'purchasing power parity'."

What it means for investors

At present, due to the absence of significant inflation, movements in nominal and real rates are similar. The main concern is to avoid being overly exposed to the short-term volatility in a particular currency.

A well-diversified portfolio is key for investors to protect against volatility in any one market, financial planners say. Investing heavily in a single country exposes an investor not only to the performance of that investment, but also to how well that currency performs.

Prof Dimson suggested low-cost, passively managed global index funds, such as those offered by Vanguard, for long-term investors.

For the best of the Telegraph's investment analysis, advice and expert opinion, plus columns from our stock-picker Questor, sign up to our weekly newsletter.