POUND COULD SUFFER FROM EU FALLOUT

RECENTLY the focus in the FX market has been squarely upon the euro, while trading in cable has been uncharacteristically quiet. While the euro has tumbled as European officials desperately try to contain the growing credit crisis in the region, sterling has remained relatively steady. Amazingly enough the pound has become a safe haven play, although the UK balance sheet is hardly a bastion of financial strength.

To understand just how skewed sentiment has become we only need to look at the latest CDS rates. In Italy the cost of insuring sovereign bonds for the next five years is now over 500 basis points, while the UK sports a much more modest rate of just 86 basis points. Italian sovereign debt is a larger portion of the country’s GDP, but the overall debt in UK is estimated to be more than 450 per cent of GDP, while in Italy it is only 315 per cent. The fact the UK enjoys such favourable CDS rates is testament to the complacency of the market and the false belief that the austerity measures have actually improved the UK’s finances.

Last week’s UK monthly Public Sector Net Borrowing report revealed that the government had to finance a record amount of debt in August as revenue waned and spending increased. Ironically enough, it was the very austerity measures implemented by Cameron that caused the slowdown in UK economic growth and resulted in a larger than expected gap in the budget deficit. All of this bodes very badly for the UK economy going forward and could force the Bank of England to resort to more quantitative easing by the end of the year.

However, the real threat to cable’s stability is the prospect of an adverse event in European credit markets. The currency market may be underestimating the exposure of the UK financial sector to the possible default of Greece. The final decision on the bailout funds is expected after the EcoFin meeting on 3 and 4 October. If the troika balks at releasing the money, euro-dollar will likely take another nasty plunge, but don’t be surprised if this time the pound follows suit.