QE means the pound has further to fall this year

EVER since Dubai plunged into crisis last November, the question of which indebted sovereign state would be next to topple has been uppermost in investors’ minds. Greece – the likeliest suspect at the time of the Dubai crisis – quickly descended into its own fiscal turmoil at the start of 2010, while the effect of contagion has left other Club Med Eurozone countries teetering on the brink.

Now that a solution appears on the cards for Greece, investors are scrutinising the balance sheets of other countries which are struggling under the weight of their own public finances. Events on Monday showed they didn’t need much encouragement to turn the spotlight firmly on Britain.

A toxic mix of political uncertainty – a YouGov poll on Sunday pointed to a Labour minority government in a hung parliament come May – a spiralling budget deficit and Prudential’s acquisition of AIG’s Asian arm saw frantic selling of sterling on Monday – the pound collapsed to as low as $1.478 against the dollar after big stop losses were wiped out at the psychologically important $1.50 level.

The pound is unlikely to stop there. Concerns about Britain’s fiscal position are likely to keep the pressure on the pound for some time to come and market analysts have already been proposing further falls to $1.20, or even parity against the dollar.

Bank of England governor Mervyn King has in the past welcomed the impact that a depreciation would have on exports and the competitiveness of the UK economy. But while a weaker pound could be good news, there is a fine line between a weaker currency and the loss of confidence in sterling and the UK economy.

Currencies Direct’s Mark O’Sullivan says that a sustained drop in the pound would lead to a sharp rise in import prices and inflation – pressuring the Monetary Policy Committee (MPC) into raising rates perhaps sooner than it would like and jeopardising the sustainability of the recovery. Hardly positive news for sterling.

And if the economy does not recover vigorously – several members of the MPC have remained steadfastly bearish on the economy’s prospects – QE might be restarted if the situation demanded it. Any whiff of restarting quantitative easing at this week’s MPC decision will push sterling even lower, says O’Sullivan.

Nick Beecroft, senior FX consultant at Saxo Bank, agrees: “Cranking up the printing presses would accelerate the pound’s collapse, but the market is coming to suspect that this is the plan.”

“Given the unavoidably tight fiscal stance that any incoming government will be forced to adopt, maybe the powers-that-be are adopting the classic solution to a debt mountain – devaluation, spurred on by an ultra loose monetary policy. Tight fiscal, loose monetary – the traditional death-knell for any currency.”

Against a backdrop of political uncertainty, a weak economic recovery and rattled markets, the MPC risks a further collapse in the pound whatever it chooses to do with monetary policy over the coming months.

As Monday proved, it doesn’t take much for speculators to start betting against the pound and any dovishness could well intensify sterling selling.