Bears prepare to pull British bulldog down

THE FUNDAMENTAL CASE

I F CURRENCIES reflect the health of their economies, there are many reasons to be bearish on sterling. Although recent data has been mixed, sterling-dollar (or cable) looks overvalued. The days of the UK’s position as an apparent safe haven look to be numbered.

MYTH OF SAFETY
The idea of the UK as a safe haven is misleading. It implies that the UK economy is strong and shielded from potential economic shocks. The term has traditionally been used for economies with steady long-term growth, stable inflation, a current account surplus, low unemployment – all helping to reduce dependence on other nations.

In fact, the UK’s current account deficit has swollen to £21bn in the second quarter – the worst number on record. And regardless of the government’s jiggery-pokery, unemployment remains stubbornly above 8 per cent, while benefit payments have risen by nearly five per cent in the last year. Public sector debt has also shot up from 62.7 per cent of GDP a year ago to over 66 per cent. Angus Campbell of Capital Spreads says “it is hard to be bullish about sterling”.

But bond yields still remain historically low. One reason is because, unlike our European neighbours, we can print currency. So, in the worst case, the Bank of England (BoE) can “monetise” debt, meaning it could print currency to pay off outstanding debts. This means that bondholders would not lose capital – in nominal terms at least.

Of course, traders are acutely aware of this. Many who were worried about the condition of the Eurozone economies recently parked cash in UK bonds – often requiring them to convert currency (typically dollars and euros) into sterling. Now that Eurozone tail-risk has been temporarily neutralised, it is not unreasonable to expect money to move in the opposite direction. Chris Walker of UBS says “outflows in the gilt market are key for traders to watch,” as money leaves gilts, sterling will come under further pressure, and the likely destination for this will be the euro and the dollar.

COORDINATED EASING
Recently we have seen coordinated central bank action. The Federal Reserve outlined QE3; the European central Bank has rolled out outright monetary transactions; the Bank of Japan and the Reserve Bank of Australia have also taken dovish stances. Many now predict further easing from the BoE, perhaps as early as November. Angus Campbell of Capital Spreads believes that “the MPC will certainly consider a rate cut, which would put downward pressure on the pound”.

After monetary easing, traders typically expect currency devaluation. However, the US dollar has held up well against sterling after the announcement of QE3. In fact, sterling has lost ground against the greenback, strengthening the bearish case for cable. Joshua Raymond of City Index believes “this was a case of buying the rumour and selling the fact”.

AMERICAN MUSCLE
Although the US is hardly in great shape itself, it still has more appeal as a safe haven than the UK: it is still the world’s largest economy and the dollar is still considered the world’s reserve currency.

Campbell argues that even with the risks of the fiscal cliff and uncertainty over the US election and Fed easing, the greenback is still attractive against the pound: “Falling off the fiscal cliff will subdue appetite for risk assets and increase the appeal of a flight to safety; traders may look to stay in cash – specifically, the dollar.” This could result in the appreciation of the dollar, to the detriment of sterling, which looks ready to retreat backwards with its tail between its legs.