The one with... Tesco, Unilever and the weaker pound

And are we experiencing a sterling crisis?

The current weakness of the pound is being driven by overseas investors’ interpretation of the UK’s political direction.

Maintaining the confidence of international investors is particularly important to governments and economies that must routinely borrow large sums of money from the markets.

Is this a sterling crisis?

Exchange rates are often driven by short-term movements in interest rate expectations.

If a currency weakens it is because investors believe interest rates will be cut.

Bond yields tell us how investors believe interest rates are going to move.

The weak sterling period from the date of the referendum until the Conservative Party conference has been characterised by falling bond yields.

However, just days ago, something quite different happened.

Bond yields began to rise, yet the pound has continued to fall.

This is akin to the kind of currency movements we see when markets lose confidence in governments and economies.

This is not a currency crisis, because the UK doesn’t have a fixed exchange rate.

A currency crisis occurs when a government is unable to maintain its fixed exchange rate because it runs out of currency reserves.

However, it is important for the UK because for many decades the economy has relied upon an ever increasing amount of foreign capital.

Uncertainty or despondency about the UK’s trading relationship with Europe may have triggered a change in sentiment about the UK as a place to invest.

Could the pound bounce back?

It would be very unusual for a developed economy with an independent and credible central bank to lose the confidence of the markets.

This is the kind of thing that happens to emerging markets.

The pound has fallen in value but it is not yet at an extreme level.

We see a nearly 70 per cent chance of appreciation from this level and a 20 per cent chance of it at least stabilising.

What does the Unilever vs Tesco spat tell us?

Retaining market access to the EU is also important.

The rather simplistic rhetoric is that the UK can demand terms because the EU runs a trade surplus with the UK.

However, the importance of surplus is misplaced.

Trade happens where the benefit is mutual and the importance of that trade is determined by the size not the direction.

Tesco threatened to de-stock Unilever goods (Hellmann's mayonnaise, Surf, Signal toothpaste to name but a few) to avoid passing on price increases resulting from the decline in sterling.

Tesco buys goods from Unilever – it runs a deficit, just as the UK buys goods from the EU.

Both companies would have lost from a stand-off, but Unilever would have lost around one per cent of sales whereas we estimate Tesco would have lost around 2.5 per cent of their sales.

The analogy is not perfect, but hopefully it demonstrates that the power in a negotiation is not based upon who runs a surplus and who runs a deficit.

UK gross trade with the EU is around 19 per cent of the UK economy, whereas EU trade with the UK is around 3.5 per cent of the EU economy.

In our view, that is the simplest expression of their trade based-bargaining position.