The British pound has fallen to a 7 year low against the US dollar and a record low against the Japanese Yen. Over the past 3 trading days, the GBP/USD has dropped more than 1000 pips or 7 percent. Consumer prices were hotter than the market expected, so what has fueled this aggressively selling?
One answer – FEAR
The market is afraid that the UK will turn into the next Spain or Greece. Over the past few months, they have been working overtime to inject more stimulus into the economy, but the more that they spend, the worse impact it has on the UK’s fiscal position. Deteriorating public finances has been the primary motivation for the recent downgrades of sovereign debt ratings by Standard and Poor’s. The FSA has dismissed this rumor but that doesn’t mean that the UK can’t be put on credit watch negative which would be one step before a downgrade. Investors are selling now and asking questions later because a downgrade would mean more losses for the British pound. Whenever a country loses its AAA rating, funds that are mandated to invest in only AAA assets need to liquidate and shift their positions elsewhere. We have seen this with Spain and could see it again with the UK.
Bank of England Governor Mervyn King will be speaking later today and he will probably attempt to calm the markets. But with employment data and the minutes from the latest monetary policy meeting due for release, his impact may be limited.
How Low Can the GBP/USD Fall?
The British pound has broken 2 key support levels – 1.45 and 1.40. Trends can last for a very long time in the currency market which is why there is a decent chance that we could see the GBP/USD slip to 1.3685, the June 2001 low. If that price level is broken, it would be a 16 year low for the currency pair. The 1.40 level is pretty critical on a closing basis. If the GBP/USD closes above 1.40 today, we may actually see a larger bounce, but don’t expect the currency pair to revisit the 1.45 level any time soon.
Monthly Chart of GBP/USD:
With the US markets closed for Martin Luther King’s Day, the odds were skewed towards a quiet trading. However, big news in Europe has made it anything BUT quiet.
After hitting an intraday high above 1.33, the EUR/USD has sold off aggressively on news that Standard and Poors downgraded the sovereign debt rating of Spain from AAA to AA+. The outlook is stable which means that further downgrades for the country is unlikely. However this could be the beginning of more downgrades in the Eurozone. Last week, Greece’s sovereign debt rating was downgraded as well to A- while Ireland and Portugal have been placed on credit watch. The reasons for the downgrades are obvious. The Eurozone is in recession and those countries have suffered greatly. Also, public finances have deteriorated materially since the governments are trying to spur growth by spending.
British Pound Below 1.45 After New Announcements by UK Government
The British pound has also fallen below 1.45 after the UK Treasury announced more groundbreaking measures to stimulate the UK economy. They have set up a program to guarantee bad debts and buy up to GBP50 billion in private sector assets. They will also be increasing their stake in the Royal Bank of Scotland. This is aimed at pumping more money into the economy and may be a step towards quantitative easing. Although the UK government has been the most aggressive in coming up with measures to turn the economy around, the British pound has sold off because investors fear that the step was taken because the outlook for the UK economy was worst than feared. They are also doubtful that the government’s efforts will pay off.
In the long run, all of the stimulus that the Brown and company have injected should make the UK the first country to recover when the global economy stabilizes. This is why I am long term bearish EUR/GBP.
Update – 5 Reasons Why the British Pound is Being Pounded – Access my latest article Feb 28, 2010
How Did the British Pound Trade in 2008?
The British pound was one of the worst performing currencies in 2008. It fell to a 6 year low against the US dollar and record low against the Euro in addition to selling off against every other G10 currency. The overwhelming weakness in the currency is a direct reflection of the impact that the credit crisis had on the UK economy. In the month of December, many currencies recovered against the US dollar, but unfortunately the British pound was not one of them. Although the pound could continue to weaken in the first quarter, the government’s aggressive fiscal and monetary stimulus should help the country recover towards the end of 2009.
Official Recession in 2009
Without two consecutive quarters of negative GDP growth, the UK economy is not technically in a recession but that should change in the first quarter of 2009, when the 2008 Q4 GDP numbers are released. Growth has been slowing materially and the weakness is reflected in the British pound. GDP growth fell by 0.6 percent in the third quarter, the largest decline in 18 years. The housing market and the financial sector have been the engine of growth in UK for the past few years and both blew up in 2008. Unfortunately the worst is probably not over for the 2 key components of the UK economy, particularly following the Bernie Madoff’s Ponzi scheme. In addition to losses suffered from the subprime mortgage crisis, many large hedge funds and European banks invested with Madoff’s. In 2009, they will be forced to write down those losses and deal with what could be pretty severe consequences for the financial sector as a whole. With the financial and housing market sectors expected to remain weak in the first half of 2009 and layoffs predicted to rise, GDP growth could fall as much as 2 percent next year. Although we believe that the country could be one of the first to recovery from the global economic downturn, this will not before more pain is felt in the UK economy. The severity of the UK recession will be largely dependent upon how quickly the credit markets are restored in 2009.
Inflation to Fall Back to 2%
As you know, I have been very bullish EUR/GBP this week. On Monday, I showed you this chart of EUR/GBP and told you that is headed for 90 cents from 87 cents and today it has pretty much reached that level. The high in EUR/GBP was 0.89978, 2.2 pips from my 0.90 target.
One of the questions asked in the comment section of my blog earlier this morning was “Is it time to sell near .90 or will it continue to slowly go up?”
As you can see in the chart below, the retracement off of the 90 cent high was pretty brutal. Although I think that EUR/GBP could hit parity, we may be due for an even larger correctionthat could take the currency pair back to 0.8750.
US retail sales and producer prices were basically in line with expectations but that does not undermine the fact that the data was very weak and confirms that the Federal Reserve will be cutting interest rates by 75bp next week. USD/JPY hit a 13 year low last night after news that the automaker bailout plan is not going happen before the new year. Everyone had hoped that the automaker saga would come to an end, but lawmakers are not letting that happen. On Wednesday, I said that USD/JPY could hit to a new 13 year. At that time, the currency pair was trading at 92.50-93.00. The possibility of the US taking interest rates below Japanese levels should keep the US dollar soft going into the Fed interest rate decision on Tuesday.
Consumer spending fell for the fifth month in a row while producer prices dropped for the second straight month. The two biggest inputs into GDP are retail sales and trade. Consumers cut back spending more aggressively in October and November which suggests that GDP growth could take a big dive in the fourth quarter, especially with the widening of the trade deficit.
GDP Could Contract by 4 to 6% in Q4
GDP could decline as much as 4 to 6 percent in Q4, which would be the largest contraction in growth since the 1980s. In the first quarter of 1982, GDP fell -6.4 percent. A 4 to 6 percent drop in GDP would not be out of the ordinary given the current conditions in the US economy. In the fourth quarter of 1990, GDP contracted by 3 percent and in the first quarter of 1991, it contracted by 2 percent. The currrent recession is worse than the one the US economy experienced in the 1990s, so a contraction in growth exceeding 3 percent would actually be expected.
The biggest drop in consumer spending came from gasoline station receipts. Prices at the pump have fallen more than 50 percent since the summer and gas stations are suffering as a result. The only silver lining in the retail sales report is the fact that not every sector saw slower sales. Electronics and sporting goods were in demand but this rebound after at least 4 consecutive months of softer spending is probably related to Black Friday sales.
BTW: EUR/GBP is at the brink of hitting 90 cents – a move that I called on Dec 8