Want to see the U.S. dollar's future? Watch the fall of the pound

03/02/2010 11:48 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Short-term politics trump long-term economics. That’s the message in the beating administered to the pound yesterday.

The implications for the United States are rather depressing.

The pound got killed yesterday (March 1), falling almost four cents against the U.S. dollar and dropping below the $1.50 level that has provided major support.

The reason? New polls that show that the Conservative Party lead in the next election, expected in May, has just about evaporated and that the country faces the real prospect of a hung parliament with no party in an overall majority.

The financial markets had been willing to cut the pound some slack despite a big current budget deficit and an economy where growth lags both the euro economies of the continent and the United States because of the belief that a Conservative Party victory would result in immediate spending cuts. But that relative optimism is in short supply now that the currently ruling Labor Party is within 2 percentage points in the polls. Experienced election observers say that the electoral system in the United Kingdom could well leave the Conservatives short of a majority even if the party wins the election,  

The price of 10-year government bonds, called gilts, has not only plunged but is now trading below comparable Italian and Spanish 10-year bonds.

The yield on 10-year gilts is now 0.976 percentage points above the yield on the benchmark German 10-year bonds, called bunds.

That’s not especially surprising given that the German budget and economy are both in better shape than their U.K. counterparts.

But the rout in the pound has pushed the yield premium on gilts above the 0.827 percentage point premium on Italian 10-year bonds and the 0.725 percentage point premium on Spanish 10-year bonds.

From a long-term perspective that’s perverse.

Both the Spanish and Italian economies face huge long-term competitive problems. Rising wages and lagging productivity have left both countries priced out of export markets for much of their production. Given the near-paralysis in Italian politics and the power of regional governments and labor unions in Spain to prevent any significant spending or wage cuts, the long-term situation in those countries is far worse than it is in the United Kingdom.

In that country what is sometimes called the parliamentary dictatorship gives any party with a majority in the House of Commons the ability to do pretty much what it pleases without a challenge from the almost powerless House of Lords or from judicial review.

That is, the long-term fix in the United Kingdom, is much easier than in Italy or Spain (or Greece for that matter.)

Which is why the prospect of a hung parliament, which would prevent the drastic action that the United Kingdom needs and which its parliamentary system makes possible, has so spooked the financial markets.

None of which should make U.S. taxpayers or investors very comfortable.

In the budget just proposed the Obama administration has punted the problem of reducing the budget deficit into fiscal 2012 at the earliest. The political odds now are that the 2010 mid-term election will reduce (at least) the Democratic majority in both houses of Congress.

Anybody think that will make Congress less dysfunctional?

The jockeying for position in the 2010 mid-terms has brought all serious legislation to a virtual standstill and the stakes just go up after those elections as the parties position themselves for the presidential race in 2012.

I know that many readers and political pundits extol the virtues of gridlock in Washington. I doubt, however, that the international bond markets feel the same way. They sure don’t when it comes to the pound. I don’t see why bond and currency traders would be kinder to the U.S. dollar.

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