The Bank of England falls off the wagon. The pound could be sore in the morning!

Another major central bank opens up the flow of more liquidity. This time it was the Bank of England (BOE). And it was only a matter of time.

The UK has been flying under the radar because there are so many different angles to scrutinize the euro zone. But the UK has been rolling over towards recession for quite some time now. You may — if you paid close attention — remember that UK GDP contracted in 4Q 2010 and trudged through with nearly no growth in the first and second quarters of this year — 0.4 percent and 0.1 percent, respectively.

No doubt, the growth deterioration there has been steady.

With that said, Thursday’s move by the BOE to enact a new round of quantitative easing was not a surprise to me. The $110 billion worth of new stimulus via gilt purchases will probably have about the same impact on the real economy in the UK as the Fed’s QE1 & 2 had on the real economy in the U.S.

The economic deterioration will continue while the British pound gets hung out to dry.

Notice in the chart below the correlation between the British pound and 10-year gilt yields. And notice the recent divergence i.e. gilt yields have fallen, but the pound hasn’t matched that fall … yet!

During each and every bout of global market risk aversion, the British pound is likely to feel the heat. And our thermometer for risk appetite is the U.S. stock market.

The correlation between the British pound and S&P 500 Index can be seen in the chart below. This tells us that another sell off in stocks, which we expect once this “oversold” rally is complete, will be yet another factor pushing down the pound relative to the U.S. dollar …

Indeed, there are plenty of negatives still swirling around Europe and the prospects for the global economy. Those bits and pieces have incited a renewed focus on backstopping a potential Armageddon scenario that would spawn in Europe. The latest efforts taken so far include Federal Reserve FX Swap Lines, BOE quantitative easing, bolstering of the European Financial Stability Fund, and the ECB considering an interest rate cut.

The IMF Chimes In

But perhaps the most active lately has been the fine folks of the IMF. Here is a quick montage of IMF-related news, in no particular order:

• IMF considers a plan to buy European bonds in the open market; it later retracts the statement.
• IMF says Latin America must prepare to inject stimulus and ease policy if crisis materializes.
• IMF suggests the Fed should not rule out additional easing measures to avoid a credit crisis.
• IMF urges the Troika not to force a larger budget adjustment in Ireland for 2012.
• IMF cuts back its 2011 and 2012 global growth projections to 4 percent after the world saw a 5 percent growth in 2010.
• IMF sees greater risks to its global growth projections.
• IMF urges action from countries so they may steer through a dangerous phase.
• IMF recommends the Bank of England loosen monetary policy if recent trends continue.
• IMF suggests the UK put fiscal tightening on hold.
• IMF suggests Canada may need to rein in the housing market, household debt accrual.
• IMF looks to double its bailout capacity to $1.3 trillion.
• IMF suggests it will consider issuing bonds to help raise additional bailout potential.

Nothing has changed — the pressure is on countries to employ stimulus, as if it were a proven solution to economic and financial crises. For without some action taken by the rulers, how will the private sector regain confidence, unleash investment, and create jobs?

Lions and tiger and bears, oh my!

The current measures being discussed could likely dictate investor sentiment until early November when it’s expected the G20 meeting will pile on even more global stimulus plans. Global policy makers’ deliberations might be enough to buoy risk appetite until then.

But come the G20 meeting, which is almost always a guaranteed disappointment, policymakers may just reveal the true weakness of the global economy and their brilliantly-concocted prescriptions.

And by that time, investors probably won’t care about the prescriptions. It’ll be time to rush for the exits again … assuming everyone hasn’t already fled before then!

A corrective bounce may be materializing for the British pound, as well as other currencies and risk assets. But don’t expect it to last too long. I think the primary trend in the British pound is down. The two charts below reflect my technical view of the pound, which I think is validated by the longer term fundamentals facing the UK and the global economy.

My most probable weekly view of the path of the pound:

My worst-case view if something develops in the global economy that is akin to what we saw during the credit crunch:

You’ll notice I labeled the projected ugly path lower for the pound as the “Global Deleveraging Crush.” I think this next phase of the crisis — a crisis that started with the credit crunch — has been exacerbated by governments and central banks creating even more debt in the global economy.

So think about this for a moment: The credit crunch was the result of too much leverage (debt) in the global economy. So the private sector starts to deleverage and instead of letting the market take its natural course, authorities add more debt to the global economy. Now the imbalances are worse than before the credit crunch.

I couldn’t make this stuff up if I tried.

Thus, I believe this story ends badly again; deleveraging globally is the only way to solve the problem if countries wish to see real growth ever again.

It won’t be pretty for most asset classes, but I suspect one asset (fiat as it may be) could surprise.

So I leave you to ponder the following chart I created showing the major cycles in the dollar index since the world’s major currencies began floating:

I believe the dollar bear market ended during the credit crunch, in March 2008. That was the major global macro event representing the catalyst; you can see how significant events like that often ignite a trend change. And global deleveraging will be the driver of the New $ Bull Market.

Why?

The process of deleveraging means dollar credit is removed; thus the supply of dollar is removed. And let us not forget that this process will likely be bad for most asset classes as I said. And where does big money hide historically during those events? In the deepest capital markets in the world, which happen to coincide with the U.S. dollar.

Best wishes,

Jack