Pressure Mounting on the British Pound

The UK economy is in a tough spot … it’s the only major economy that has yet to emerge from recession. It’s running the largest budget deficit of any industrialized country. And its central bank has thrown everything, including the kitchen sink at the problems trying to stimulate economic activity.

While the U.S. and the Eurozone are talking exit plans for extraordinary stimulus, the UK has re-upped its asset purchase program, twice. And major UK banks have been nationalized by the government, recently requiring even more cash injections.

The British political leadership is under fire for leading the country into its longest, deepest recession and biggest budget deficit since the second World War. Consequently, infighting has polarized legislators and policymakers.

Recipe for Pain …

The Brits haven’t seen an economy this bad since WWII.

As you might expect, none of the above is a good recipe for currency stability.

However, since June of last year, the pound has managed to maintain a fairly stable range against the dollar. Yet it has had a steady fall against most other currencies.

Through the past six months the pound lost:

• 17 percent against the New Zealand dollar,

• 16 percent against the Australian dollar,

• 12 percent against the Brazilian real,

• 8 percent against the Canadian dollar,

• 6 percent against the Japanese yen, and

• 3 percent against the euro.

On top of that the pound lost 27 percent against gold. That’s a bigger slide than the dollar experienced against gold over the same period … even as the buck was battling a landslide of attacks!

Moreover, I looked up the performance of 63 world currencies since June of last year. Of that group, the pound only outperformed the currencies of Nigeria, Iceland, Argentina, Jamaica, Iran, Vietnam and Pakistan — and just marginally. A common thread in those seven countries: Instability.

Such performance argues for a sharp slide in the pound versus the dollar if the dollar continues with its bounce back of the past month.

More Pain Ahead …

This week, the news got worse for the UK government: It was reported that PIMCO, the largest bond fund manager in the world, announced that it would be a net seller of UK government bonds this year citing the burgeoning debt load in the UK and feeble economic prospects. They went further to say that they have assigned a high probability on the prospects that the UK will lose its AAA credit rating on sovereign debt.

“The [UK] government’s debt reduction is lacking in conviction and it is lacking in details.” — Scott Mather, PIMCO’s head of global portfolio management

Given the problems in the UK and with sovereign debt problems on the rise globally, the cost of insuring UK debt has nearly doubled since October.

For a while, the aggressive policy responses by the Bank of England and the UK government were being praised in the market. That’s in part why the pound rallied off of the lows of its 2008 plunge. But over time, it’s become clear that even with the aggressive easy money policies, the UK economy is still not showing the encouraging signs seen in the U.S. and Eurozone economies. And the internal and external pressures to curtail the budget deficit threaten to stifle recovery efforts.

With the evidence weighing heavily against it, the pound looks vulnerable for another tumble. According to Bloomberg, BNP Paribas is looking for the pound to fall 12 percent against the dollar this year. That would mean a move from current levels down to 1.40 vs. the dollar.

If you look at the chart below, you can see the pound’s dramatic fall from its multi-decade highs as the global financial system began to unravel. In fact, it ultimately plunged 36 percent against the dollar.

Source: Bloomberg

Subsequently, you can see the retracement that has taken place over the past year. But while many currencies have had aggressive recoveries following a sharp crisis-induced collapse, the pound’s retracement has been relatively shallow.

With few technical barriers keeping the pound afloat, a break of the October lows of 1.5708 would likely mean an accelerated slide for the British currency.

Regards,

Bryan

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