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The resilience of the British Pound is nothing short of impressive. Normally, if a ratings agency cuts the credit outlook for a country, the currency falls.  We saw this reaction when Ireland, Spain, Portugal and Greece were first put on credit watch negative and then when their ratings were downgraded.  The Pound received a beating when the news first broke shortly after the London open, but the currency pair has recovered as 1.55 proves to be strong support.  The British pound has even bounced against the euro, which indicates that some traders are unfazed by the weaker credit rating outlook.

How Serious is the Threat of a Downgrade?

Having lowered the outlook on U.K. debt from stable to negative, Standard and Poor's believes that the country stands a 1 in 3 chance of losing its AAA rating.  S&P has not been shy of stripping Eurozone members of their AAA rating, but downgrading U.K. debt would have more significant ramifications and so the ratings agency will not take the decision lightly. S&P is worried that the aggressive spending pattern of the U.K. could drive their debt to GDP to 100 percent in the near term.  However at the same time, this spending is exactly what everyone hopes will revive the U.K. economy and allow the government to reduce their debt burden.  U.K. retail sales increased for the second month in a row, which indicates that there is light at the end of the tunnel. The results of the latest bond auction was also decent, suggesting that foreign demand is holding steady.  Therefore we think that the chance of an actual downgrade is low at this time.  

Impact of a Downgrade on the British Pound

When Ireland, Spain, Greece and Portugal were downgraded, some investors fled out of euros, but most just shifted their investments to other members of the eurozone.  With the U.K., there is no place to hide if the country's credit rating is downgraded.  The biggest beneficiary would be the U.S. dollar and Treasuries as long as the U.S.' credit rating is not placed on watch as well.  Many global funds are mandated to invest only in AAA assets and therefore a downgrade could trigger significant selling of British Pounds. The currency's reserve status could also be at risk.  

More Countries to Come Under Review

S&P is starting to examine G10 nations and there is a decent chance that the U.S., Germany, France, Italy, and Japan could come under review as well.  If everyone is scrutinized and placed on credit watch, there would not be as much of a stigma. According to the IMF, the U.K.’s debt load next year will be 66.9 percent of GDP (compared to S&P's fear of 100 percent), exceeding Canada’s 29.1 percent and Germany’s 58.1 percent. The U.S. will be at 70.4 percent, and the 16-nation euro area at 69 percent. This means that the situation in the U.S. and Eurozone is not all that different from the U.K. However for the  time being, it is a standalone problem for the U.K. that should cap the gains in the GBP/USD until S&P downgrades the outlook for the U.S.

  Government Debt Rating Worrying Investors

About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.