With a currency plumbing new depths in the face of unprecedented political instability, it has become fashionable to compare the UK to an emerging market.
But even if a no-deal Brexit were to propel sterling to parity with the dollar — as some analysts have predicted — in one crucial sense Britain remains firmly rooted in the developed world.
Nobody, it seems, is betting on a simultaneous meltdown of the currency and the domestic bond market — as frequently happens in a proper emerging-market crisis. Investors are also reluctant to believe that the Bank of England would be forced to hike interest rates to prop up the pound (which would capsize the bond market) — even though the Bank suggested in its Brexit analysis late last year that it could conceivably be forced to do exactly that. Markets are pricing a better-than-even chance of a rate cut by the end of the year. After a no-deal Brexit, most traders think it would be a racing certainty.
That is why every Brexit-induced swoon for the pound is accompanied by a rally in UK government bonds. Sterling sank to just above $1.20 this week, its lowest against the dollar in nearly three years, before rebounding a little, while gilt yields tumbled to record lows. The investor playbook is straightforward: crashing out without a deal will hurt growth, forcing the BoE to respond with rate cuts or even a renewed bond-buying programme.
Political risks have only added to the hunger for UK government bonds. Investors at home and abroad are desperate for any bonds with a positive yield, and gilts retain their haven status. The currency vigilantes might be taking sterling to the woodshed, but the bond vigilantes are nowhere to be seen.
So all those jibes that the pound should be renamed the “North Atlantic peso” are, for now, just a bit of fun. Any attempt to draw parallels with a south Atlantic namesake in Argentina sounds like hyperbole.
Even so, market correlations are not set in stone. A chaotic Brexit is currently seen as positive for gilts today, but what about in three months’ time?
It is far from a consensus view, but some investors are questioning the conventional wisdom. Gene Frieda, a London-based strategist at Pimco, says there is a lively debate currently taking place within the firm, which is one of the world’s biggest bond investors.
Mr Frieda, whose background is in emerging-market investing, is one of the pessimists. “People who have dealt with EM see a wider range of possibilities than people who have dealt mainly with developed markets,” he says. “Britain is a country that looks EM-like in that it has a large external borrowing requirement. That creates a certain volatility.”
A current account deficit of 5.6 per cent of gross domestic product is a vulnerability also highlighted by BoE governor Mark Carney, who has warned that Britain is reliant on the “kindness of strangers” to fund it.
Mr Frieda thinks a messy no-deal Brexit could test this kindness to breaking point, by undermining foreign direct investment in the UK. The resulting weakness in the currency could create an inflationary spike that the BoE would be unable to ignore. Market expectations of inflation in the UK are already well above those in the US or the eurozone. At some point, they would be too much for bond investors to bear.
At the same time, sterling’s status as a reserve currency could be threatened, particularly if Brexit turmoil is followed by a Jeremy Corbyn-led government intent on nationalising large swathes of the economy.
For many investors, the left-wing programme pushed by Mr Corbyn’s Labour party has shades of the 1970s — a reminder of an era when a currency meltdown saw Britain going cap-in-hand to the International Monetary Fund.
Even without a change of government, prime minister Boris Johnson’s pledge to spend big to offset the economic impact of Brexit — funded by a borrowing spree — is leading some investors to question whether gilts are vulnerable to a sell-off.
There are powerful forces acting against such an outcome. Roughly a quarter of UK government debt is currently in the hands of foreign investors — a much lower proportion than France or Germany, where the comparable figure is about half. It is difficult to see those investors heading to the exit en masse in a world where almost $17tn of bonds are trading with negative yields.
Even if they did beat a retreat, the UK (unlike a typical emerging market economy) has a large and stable base of domestic investors. An exodus of foreigners could be offset, in theory, by a flight to safety within sterling assets.
Moreover, when it comes to the BoE, the bar to raising rates to defend the currency — and thus upsetting the bond market — would likely be very high. Recall the long period of above-target inflation (topping out at more than 5 per cent) in the wake of the financial crisis that the BoE was happy to tolerate while holding rates at record lows.
Still, it is remarkable that heavyweight investors are even debating the idea of the UK as an emerging market. If it does come to pass, the proof will not be in a turbulent currency but in the bond market.