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Does the Collapse of the Pound Foreshadow Dollar's Fate?

Last updated 1/21/2009 11:54 AM ET (GMT -5) 0 Comments - Add your comment

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Boris Schlossberg

Director of Currency Research, GFT

The drop in the GBP/USD at the start of this week has been nothing short of astonishing. In less than 48 hours the pair erased more than 1000 points off its price depreciating by more than 6% against the dollar. Although cable has been in decline since the turbulent markets of last fall, this latest freefall carries a whiff of true panic about it as markets fear that that UK government spending schemes  to rescue the country’s ailing banking sector will put unsustainable stress on the Treasury.

The run on the pound  was triggered by Prime Minister Brown’s latest proposal to spend an additional 50 billion GBP to insure  toxic assets of the banks,  as well as by the RBS revelation of  the largest loss in UK corporate history. Those two events have greatly damaged the markets confidence in UK financial system, sending sterling plummeting as traders  question the UK government’s ability to successfully float so much fresh public debt as 2009 unfolds.

Less than eight months ago cable was trading above two to the dollar. Starbuck’s lattes in London cost eight bucks a cup, and almost no one envisioned such a complete collapse of the currency. What happened? The credit crunch. More than any other G-10 nation, UK became synonymous with finance. It turned into the world’s first hedge fund  economy. Fully 50% of all UK employment growth this decade came from the financial sector as London  made full use of its intermediary status  between the petro dollar economies of Russia and the Middle East and the vast capital markets of North America.  For a period of time London even challenged New York as the financial capital of the world.  Those heady times led to a record 46 consecutive quarters of economic growth fueling unprecedented wealth along while driving unemployment to an ultra low 2% rate.

However,  the collapse of global capital markets turned  the UK economy  from  boom to a bust in a blink of an eye. Despite inflation levels that remain above 3%  the BoE has lowered rates from  5.25%  to 1.5% in less than 12 months as UK unemployment rolls swelled to 6.1% and UK finance sector reeled from  record losses on credit instruments. Looking forward, there is little hope on the economic horizon. The unbalanced situation of the UK economy persists and should global equities remain in a protracted bear market, the long term damage is likely to be severe.

The BoE policy is relying on the assumption that lower currency values will address some of those imbalances, but so far that thesis has failed  as the country’s Trade deficit continues to swell. UK may now face a true nightmare as the economy continues to contract, but inflation levels rise due to the weakness of the currency and the UK government’s inability to raise new capital at reasonable interest rates.

While   the events of the past few days have certainly punched the pound in the solar plexus, the currency of another Anglo-Saxon economy just across the Atlantic has remained strong and steady. Nevertheless, while the greenback may appear to be a rock of stability amidst the recent  turmoil of the currency markets, the pound saga may serve as a cautionary tale for greenback longs.

The very same reasons that felled sterling this week, may also bring down the dollar. Much like the UK economy, the US economy has relied on the financial sector for the majority of its recent economic growth. At its height the US financial sector represented more than 20% of the S&P but the double collapse of US real estate and equity markets have wiped $10 Trillion off household net worth bringing consumer spending to a standstill. With the consumer representing 70% of the US economy this sharp contraction in demand brought all economic growth to a virtual halt.

Up to now the dollar has ignored this negative economic backdrop as global capital flows have continued to pour into the safety of US Treasuries, driving the yield on four week T-bills to practically zero. Yet the critical question facing  the currency market in 2009  is how long will global investors give US a free ride on their money?

One of the primary suppliers of capital to the US is China and recent capital inflow data indicates that the Chinese have shifted the vast majority of their investment portfolio away from Agency bonds (such as Fannie Mae and Freddie Mac) towards Treasury securities. In other words US now finds itself in a precarious position where a significant portion of its debt resides in short term obligations subject to rollover risk.  Should the Chinese lose faith in the “full faith and credit”  of the United States the downside pressure on the dollar could be enormous as capital flight will surely ensue.

To aggravate the situation further, the current stimulus plans of the Obama administration are likely to add an additional $1 Trillion of spending at a time when tax revenues are falling off a cliff. The dangerous combination of record new  spending and near total reliance on foreign capital to finance such spending creates  the primary risk to the dollar  this year. While, the chance of an immediate global run on the greenback appears to be relatively small, since  the unit continues to serve as the reserve currency to the world offering  the best choice amongst many unpleasant alternatives, currency  traders should not be complacent.  The vicious run on the pound stands as a stark lesson of how quickly sentiment can change in the FX market. With so much debt outstanding and so much more to be issued, the dollar could indeed  become the next “pound” in the  currency market and traders should prepare accordingly.

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About The Author

Boris Schlossberg began his Wall Street trading career more than 20 years ago at Drexel Burhnam Lambert. There, he traded nearly every type of financial product on the market in the U.S., from equities and options to stock index futures and foreign exchange. His innate ability to analyze market information and use it to trade has helped him become an industry-recognized, “go to” trading professional.

These days, whenever the markets move, many organizations turn to Schlossberg for his take on the situation. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of Technical Analysis of the Currency Market and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Kathy Lien. He joined GFT in 2008.