The sovereign debt crisis turns from Greece to the United Kingdom

03/15/2010 2:40 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Everybody hates the pound sterling.

As of March 9 the futures market showed a greater proportion of bearish bets against the pound than back in September 1992 when currency traders wagered that the British government wouldn’t be able to defend the pound and keep the country in the European Exchange Rate Mechanism. That system, a precursor to the euro, required countries to keep their currency within a trading band against other currencies in the system.

When the United Kingdom government finally threw in the towel and let the pound slide it fell 24% in three months. Traders made millions or more: George Soros’ Quantum Fund made $1 billion.

So far this year the pound has lost 6.9% on fears that either the economy will stall short of full recovery or that the government won’t be able to rein in spending—or both. This most recent fall, though, is part of a longer pattern of decline. The pound is down 38% since 1974 against a basket of currencies from the world’s 10 largest economies, according to Bloomberg.

The United Kingdom economy has been the slowest of the world’s developed economies to recover from the global slowdown. In recent months the numbers have actually taken a turn for the worse with factory production falling in January—for the first time since August—and the trade deficit climbing to the biggest gap in 17 months. Forecasters, including those who work for the Labor government, have been left scratching their heads as an expected surge in exports from a cheaper pound has failed to materialize.

But the biggest problem is that the Labor government of Prime Minister Gordon Brown has been singularly inept in its efforts to assure the financial markets that it has a plan for reducing a deficit projected by the government to hit $270 billion in fiscal 2010. (The U.K. economy is about 6.5-times smaller than the U.S. economy so this deficit is equal to $1.7 trillion in U.S. terms. The huge U.S. budget deficit is projected to hit $1.4 trillion in fiscal 2010. For 2009 the U.K. deficit is estimated at 12.4% of GDP. In Greece the deficit hit 12.7% of GDP.)

The financial markets have already rejected the government’s plans for reducing future deficits as based on overly optimistic projections for 3.5% annual economic growth from 2011 on.

In the fourth quarter the U.K. economy grew by 0.3% but on March 15 Kate Barker, a member of the monetary policy committee at the Bank of England roiled financial markets by saying that country could see a one-quarter return to negative growth.

The financial markets had been counting on a victory by the Conservatives over Labor in national elections that much be held by June 3 to restore some fiscal credibility. (The markets are often hopeful that a change in administration will result in spending cuts.) But the race has tightened in recent weeks leaving the markets to confront the possibility of nobody winning a decisive majority.

The degree of uncertainty about the direction of the pound and the depth of the crisis in the United Kingdom is extreme. Bloomberg reports predictions of a drop in the pound to $1.30 by the end of 2010 or a rally to $1.73 by August. The pound now trades at approximately $1.50.

That’s more than enough uncertainty to keep financial markets on edge. The Greek crisis may be over (well, at least it’s out of the headlines for a few months) but investors and traders already worried about potential over-tightening in China still have a European crisis to watch with their other eye.

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