Selling England by the Pound

01/15/2008 12:00 am EST

Focus: GLOBAL

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of Global Bull Market Alert, says the British pound may be the world’s most overvalued currency and it’s set to fall further.

During the last six weeks, the British pound has taken over the US dollar’s role as the whipping boy of the currency markets. Since touching an eye-popping $2.11 in November, the pound has dropped by more than 7% and fallen through the $1.96 level this past week. Here's why I think the British currency is set to fall at least another 15% during the next three to six months.

First, the negative news coming from the United Kingdom during the past few weeks has been relentless. Economic growth seems likely to slow sharply, short-term interest rates are set to fall, and capital markets are suffering credit-crunch blues.

And while subprime woes are grabbing headlines in the US, the UK’s position is by almost all measures worse than that of the US. The run-up in UK house prices was much bigger and housing valuations and household indebtedness are still more extreme than in the US market.

At the end of 2006, UK household mortgage debt was 126% of GDP, against a mere 104% in the US. The UK's current account deficit, at 5.7% of GDP in the third quarter of 2007, also was bigger than that of the US. Indeed, some experts estimate that the United Kingdom's true current account deficit is actually closer to 7% of GDP.

Second, the British pound is probably the most overvalued currency in the world. As any of you who have traveled to London in the past few years can confirm, $1.96 buys far more in the US than £1.00 does in the UK. Morgan Stanley estimates that in purchasing parity terms, the pound should be trading at around $1.64 to the dollar—just about the average dollar exchange rate since 1985.

Bank of New York Mellon notes that the British pound is almost 18% above long-term averages compared with the dollar. In fact, BNP Paribas points out that the British pound is now more overvalued than it was on that fateful day in September 1992 when George Soros "broke the Bank of England"—and made $1 billion in the process—by betting that the UK would devalue the British pound.

Third, once the bottom drops out of a currency, it tends to overshoot, both on the upside and the downside. In the last few weeks, the pound has fallen like a warm knife through butter. Not even the Bank of England's decision to keep UK interest rates on hold at 5.5% last Thursday could steady its free fall.

So sell the CurrencyShares British Pound Sterling Trust (NYSEArca: FXB) at market (it closed around $196 Monday—Editor), and set your stop (buy back price) at $205. Because FXB is such a low-volatility play, you won't get the kind of potential returns from the options you would get on stocks. But if you do want to play the options, I recommend the June 2008 $197 Put Option (FXBRO.X).

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