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

01/22/2009 10:29 am EST

Focus: FOREX

Boris Schlossberg

Managing Director of FX Strategy & Co-Founder of BKForex LLC, BK Asset Management

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 1,000 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 the UK's 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. Starbucks 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, the 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 while driving unemployment to an ultra-low 2% rate.

However, the collapse of global capital markets turned the UK economy from boom to 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 the 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. The UK may now face a true nightmare as the economy continues to contract, but inflation levels are rising 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 from 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 the US a free ride on their money? |pagebreak|

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), and towards Treasury securities. In other words, the 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 a 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 in 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.


By Boris Schlossberg of

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