UK Housing Bust Spells Trouble for Pound

I’ve pointed out many times here in my Money and Markets column that interest rates and economic growth are always the two primary fundamental drivers of currency prices. Therefore, it’s no stretch to conclude that housing has been the Achilles’ heel for the U.S. dollar.

But what if there’s another major currency country that has a much worse outlook for its housing market? Would we then expect bad housing news to play a similar role in pushing its respective currency lower? I think the short answer is: Yes!

It’s fitting on this Independence Day holiday weekend that we examine the incredible exposure to housing prices in our motherland — the UK — compared to the U.S. And once you take a look at the ugly factoids in context, I think you will understand why …

The UK Economy and Pound Are In Trouble

I recently read this poignant comment by Jim Grant, long-term editor and market sage for Grant’s Interest Rate Observer:

“The full catalog of the consumer’s troubles would fill out a Sunday-morning sermon in a Puritanical meeting house. Improvidence compounded by idolatry — yea, the worship not of graven images but of houses — is the sum and substance of the situation.”

Clearly, the pricking of the housing bubble was the catalyst for the downward spiral in the U.S. economy. It has paved the way for lower interest rates and varying degrees of desperate measures from our Money Gods — the Federal Reserve.

But if you think the U.S. has economic issues, get a load of the extreme exposure to housing the UK’s economy is grappling with …

UK consumers have about $278 billion in residential mortgage backed securities (RMBS). This is the toxic derivative-related stuff; RMBS are the dirtiest four letters in “The City” right now. UK exposure to RMBS is the largest exposure in Europe by far.
Britain’s total RMBS exposure is dwarfed by the $4.39 trillion racked up in the U.S. But as a percentage of total GDP, the UK RMBS exposure is a whopping 7%, whereas the U.S. RMBS exposure to GDP is a miniscule 0.2%.
Residential mortgage debt outstanding per capita in the UK is 136%; it is 103% in the U.S.
Residential mortgage debt to GDP in the UK is 51%, compared to 44.5% in the U.S.
Debt to disposable income for the UK consumer is 164%, compared to about 138% for the U.S. consumer.

You may not be too impressed with these numbers. But keep in mind, since 1996 UK housing prices have tripled, whereas U.S. housing prices only doubled. And if you believe as I do in reversion to the mean, i.e. that prices sooner or later come back to a natural historical path; you can see why the UK is much more exposed to a downturn in housing than the U.S.

As the chart below overwhelmingly reflects, the UK housing price downturn is now well under way and beginning to accelerate.

June marked the eighth consecutive month in a row that housing prices have fallen. And year-over-year prices are down 6.3%. That’s miniscule considering how far prices have risen in this cycle.

“The latest data on the housing market are undeniably alarming,” said Howard Archer, chief European economist at Global Insight in London, who expects prices to fall 12 percent this year and next.

“The marked deterioration in sentiment over the housing market also heightens the risk that house prices will fall sharply over the next couple of years,” according to the International Herald Tribune.

But what if prominent economists are wrong?

Given that UK consumers are straining under the weight of debt, which is leading to a soaring number of personal bankruptcies — a 30% increase year-over-year through March 2008 — I think a 12 percent price fall forecast for UK housing in 2009 is grossly underestimated.

And on the institutional side of the fence, things are just as bad or worse. UK housing stocks trading on the London Exchange have been decimated, and some are teetering on the edge of bankruptcy. One of the biggest market players, Taylor Wimpey, saw its stock plunge 55% on Wednesday after the company revealed it will need a cash infusion to stay afloat.

Late last year, the UK government stepped in to save one of the country’s biggest mortgage lenders — Northern Rock. I expect we will see more rescues like this in 2009. But the exposure is tremendous, and there will likely be major bankruptcies that will only add to the deteriorating sentiment toward the sector.

While housing will no doubt continue to be the Achilles’ heel for both currencies, I believe that the UK economy is much more exposed to falling housing prices than the U.S. economy.

Bottom Line: I continue to a long-term bear on the British pound and believe any rallies in the currency represent an opportunity to enter short at a better price. Selling the pound against the dollar with a 10-12 month time frame may present one of the best opportunities in the currency markets today.

Best wishes,

Jack

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