A less than sterling analysis

The British Pound sterling has suffered more from the financial crisis and recession than any other major currency. From its high point of just over 2.1100 in November 2007 to its Friday close at 1.3812, the Sterling has lost 35% of its worth against the U.S. dollar. It has sustained similar losses against the yen, 51%, the euro, 44%, and the Swiss franc, 36%.

In comparison, the euro has declined only 19% against the U.S. dollar, 32.1% versus the Japanese yen, and 11% against the Swiss franc. The Australian dollar has lost 33% against the U.S. dollar and 46% against the yen. The Canadian dollar has fallen 26% against the American dollar and 43% against the yen but gained 9% against the euro. The Swiss franc has dropped 20% against the U.S. dollar and 27% against the yen while gaining the above 11% against the euro. With the exception of the yen crosses, which were the beneficiary of the funding-based carry trade and whose destruction in a welter of deleveraging, repatriation and capital flight is a story apart from the general market, the sterling has forfeited more value than any other industrial world currency.

The immediate economic and interest rate prospects can account for a large part of the market disenchantment with the pound. But there are also secondary concerns, the British sovereign debt outlook, the health of the banking system, the pending election and even the trading history of the pound, which although not as quantifiable as interest rates or GDP add considerably to a sterling trader's worries. Unfortunately for the British public and the government not one major criterion is positive for the pound.

The Bank of England (BOE) has been more forthcoming about the condition of the economy and more aggressive in reducing rates to meet circumstances than its counterpart across the channel, the European Central Bank (ECB). But it has lagged far behind the American Federal Reserve. Though the current BoE 1.5% repo rate may be an historic low across more years of existence than any other central bank, it is very likely that rates will move even lower in the immediate future. The BoE does not have the anti-inflation mandate of the ECB or the institutional credibility of the Bundesbank. Mervyn King, the BOE Governor, may warn the market of the dangers of ultra-low rates but in the end, he will take the bank down the same path as the U.S. Federal Reserve. Aside from other considerations, the British economy will have suffered from the delay.

Gross National Product in the United Kingdom plunged 1.5% in the last three months of 2008. It was the largest economic contraction since 1980. The British housing market has experienced a credit fueled real estate boom like the U.S. and is mired in oversupply, falling prices and bankrupt mortgage lenders. Unemployment is at 6.1% the highest since 1997, claims jumped 77,900 in December and consumer spending and confidence are sinking. Industrial and manufacturing outputs were down 6.9% and 7.4% respectively on the year in November.

The British banking system is not as diverse as that of the United States and is centered on a few large institutions. The Royal Bank of Scotland is one of those key institutions and the government now has a 70% stake in ownership. While wholesale nationalization of the banking sector is not contemplated nor spoken of by the government, as more banks come to depend on government rescue funds the result is a nationalized industry, in fact if not in declaration. Financial services accounts for a large part of the British economy. A government controlled banking industry will be neither as profitable nor as expansionist when the recession finally ends as it would have been under private stewardship. The difference for the British economy will be fewer jobs in a less productive financial sector for years to come.

Standard and Poor’s reaffirmed the British AAA rating on Jan. 13 but the longer-term prospects are still questionable. The government has assumed many of the liquidity problems of the banking system. In so doing, the government has vastly expanded its debt and risk burdens. If markets continue to fall, analysts and the rating agencies will posit more bank recapitalizations and more private sector debt on the government books. Spain, Portugal and Greece have already had their ratings reduced and they have the benefit of belonging to the united European currency. In the newly stringent rating agencies, concern for British debt rations will weigh far more heavily than consideration for government funding costs or British chagrin.

Gordon Brown's Labour Party is trailing badly in the polls. The deciding factor in the U.S. election may have been the state of the U.S. economy and the financial market blowup in September and October. Prior to that intensification of the financial crisis, the two candidates, Barack Obama and John McCain, were essentially tied. The lesson will not have been lost on Brown. Nothing determines an election in a democracy like the state of the domestic economy. Market suspicion has to be that the Brown government will do whatever it can to prop up the economy before the election, including lower rates, massive fiscal stimulus spending, and quantitative easing when rates have reached a nadir. Nothing that will help the Labour cause and the economy will support the pound. Every measure can be justified by the need to rescue the economy from recession or worse. If the pound is sacrificed in the attempt, so be it.

Finally, trading historians will remember George Soros and the European Exchange Rate Mechanism (ERM). In the fall of 1992, Soros bet that the Conservative Government of John Major would be unable to maintain the pound within the trading band of the ERM. The currency markets believed Soros and joined in the most famous currency raid in history. The sterling was forced out of the ERM and the Conservative Administration’s reputation for fiscal competence was shattered. Today there is no ERM and no central bank trying to hold back the weight of the currency markets. But currency traders still hunt in packs and they are stalking the pound sterling.

Joseph Trevisani

FX Solutions LLC

Chief Market Analyst


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