Once it was the bedrock of the world's financial system. Now, it's the weakling.
The big question is what's next for the British pound sterling, which has lost 17% of its value since the country voted to leave the European Union in June. It's now worth about $1.22.
This decline is primarily due to the confusion caused by the vote. No country has ever left the European Union, and investors aren't sure how much the departure will hurt Britain's international trade or whether the world's fifth-largest economy will be able to retain the so-called passporting privileges that helped the City of London position itself as an international banking center.
Passporting allows companies licensed by one EU member to do business in all of them, and losing that privilege would make Britain less attractive to companies with operations across Europe. Indeed, JPMorgan Chase (JPM) - Get Report CEO Jamie Dimon said before the Brexit vote that a decision to leave might force the company to relocate as much as 25% of its British workforce.
"We are at a point where the currency is pretty vulnerable," says Ken Dickson, investment director for currencies at Standard Life Investments in Edinburgh, Scotland. "There are few reasons why you'd want to buy sterling until the uncertainty lifts."
The largest risks for investors include the following:
- A hard Brexit. Basically, that's a scenarioin which Britain leaves the E.U. without retaining the free trade deal it currently has. "A hard Brexit carries a much greater risk of economic dislocation as investment plans are put on hold by U.K. businesses, and by foreign ones," says Tom Elliott, international investment strategist at deVere Group.
- Interest rates. "There is the possibility of higher U.S. interest rates and possibly lower ones in Britain," says Elliott. Typically, higher borrowing costs bolster a currency, while lower ones weaken it. The combination of the two countries moving rates in different directions would make for an even bigger move in currency values.
- Reserve currency. The UK's reserve currency status could be at risk, says rating agency Standard & Poors. Reserve currency status means central banks around the world have an incentive to hold pounds, buoying the currency's value. Losing that status could be costly to British purchasers.
- Scotland breaking away. Scotland's First Minister, Nicola Sturgeon, has published a draft bill on a Scottish independence referendum. In 2014, Scotland voted to remain within the United Kingdom, largely because splitting off would have cost the country its EU membership.The potential breakup of the U.K. after three centuries would add further investor anxiety, since Scotland would almost certainly seek to be part of the EU, giving it an edge that England would be losing. Indeed, Sturgeon's government said having the referendum available would "allow all options to be available to the Scottish Parliament to protect Scotland's continuing relationship with Europe."
- Article 50 trigger. Yet more confusion arises over which institutions in Britain have the authority to trigger leaving the EU or what they can negotiate. British judges heard arguments this month over whether the government can trigger Article 50 of the EU rules, which would start the process of breaking away from the confederation, without a Parliamentary vote. Prime Minister Theresa May's administration has maintained it can.
- No written constitution. The lack of a written constitution clearly defining which powers are held by the different branches of government only makes speculation wilder. The British constitution currently comprises statutes, such as the Magna Carta -- or Great Charter -- of 1215 and bills passed by Parliament, as well as case law interpreted by the courts.
So where does the pound go next?
Standard Life's Dickson says the currency is fairly valued at about $1.25, and there's "real risk of it weakening further because of lower business investment in the short to medium term," he says.
Investors who see weakness ahead might want to consider shorting the CurrencyShares British Pound Sterling (FXB) - Get Report exchange-traded fund, which tracks the value of the British pound. Shorting involves selling borrowed shares with the hope that profits can be made from a price decline.
Small investors should avoid trading currencies with borrowed money, also known as margin. Losses can accumulate quickly and the foreign exchange markets are dominated by large professional investors and central banks such as the Bank of England.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.