An extended downturn in the British pound in the first quarter of 2008 has been a reflection of the deteriorating fundamentals underlying the struggling currency. Although the sterling plunged to new lows against most of the other majors, the move was far more tempered than the sharp decline that we saw between November and December. In fact, the GBP/USD closed the quarter only 15 pips from where it opened. However, such stability against the unstable US currency certainly does not reflect the ailing economic situation in the United Kingdom. Catching the global growth flu, economic activity has cooled considerably and is expected to decelerate much further in the months ahead. This has in turn led to speculation that the Bank of England will step up its efforts to ease monetary policy. Beyond London’s title as the financial center of the world, the freeze in lending exposed a particularly vulnerable housing market, banking sector and debt-ridden consumer. With the financial crisis taking a firmer hold on the health of the global economy, it seems as if the pound is in a position to follow in the offsteps of the US dollar.</strong>
Domestic activity in Europe’s second largest economy has clearly shown signs of stumbling in recent months. According to the Office of National Statistics, growth through the end of 2007 cooled to a 2.8 percent annualized pace – matching the slowest clip of expansion in nearly two years. In comparison to activity in the US, which came to a near stand still over the same period, growth in the UK may look otherwise impressive. However, key sectors of the economy have clearly stumbled and threaten to sabotage activity going forward. The biggest anchor to expansion going forward is from the souring of the decade long housing boom, which threatens to erode consumer wealth. The average Brit is in no position to absorb a loss in wealth on par with Americans as Brits are already floating 1.4 trillion pounds of personal debt. In fact, over the fourth quarter, personal consumption grew a sparse 0.1 percent. Despite a steady drop in unemployment to its lowest rate since 1975, consumer confidence fell to a 15 year low in March, suggesting that spending will continue to contract going forward.
What’s more, there seems little hope for other sectors to fill in for the shortfall. Business activity has slowed as managers respond to the expected downturn in domestic spending and the astronomical rise in raw material costs. Demand from outside the country also offers little reprieve. Orders from the US and other major trade partners have cooled with the downturn in global growth, pushing the trade deficit to a record in recent months. To make matters worst, the reversal in the exchange rate from a 26-year high may be coming too late to significantly offset the fading demand for exports. Even given these and other factors, Finance Minister Alistair Darling has projected a sparse 2.0 percent pace of growth through 2008. The Monetary Policy Committee is surprisingly more pessimistic, looking for a 1.6 percent clip through the fourth quarter – which would be the slowest rate of expansion since 1993.
[B]A Housing Collapse That Could Rival The United States’[/B]
The recession in the US housing market – the worst in a quarter century – is well known around the world. However, this focus may be drawing attention away from the next major collapse: the UK housing market. Since the turn of the year, activity in the British residential market has cooled significantly. From the most recent indicators, it is clear that problems in the credit market and the fading outlook for growth are taking their toll on a decade-long boom. HBOS, the country’s largest mortgage lender, reported a 2.5 percent drop in prices through March – the largest monthly contraction since 1992. Offering similar results, Nationwide reported four consecutive monthly contractions in residential inflation through March, marking the worst streak for the data series since 2000. Altogether, economists have deemed this the worst housing slump for the UK since last recession in 1991; and this is remarkable because it may only be the beginnings of the correction. The IMF, in a recent report, judged that the British housing market was still 33 percent overvalued; so what has been seen so far may only be the tip of the iceberg.
[B]Credit Market Conditions Roil The Global Financial Leader[/B]
Through the first quarter of 2008, there has been no greater concern for central banks, policy makers, trading houses and investors than the pervasive credit market freeze. From a global standpoint, few countries stand to lose more from a prolonged and severe crisis than the UK. British commercial banks and lenders have nearly buckled under the pressure. If fact, the failure of a major financial institution no longer seems an unlikely event. The emergency rescue of Northern Rock turned out to be more difficult than officials had originally thought. After failed attempts to find an acceptable bid in the market, the government was finally forced to nationalize the troubled company to insure against its failure and the loss of billions in customers assets. More recently, the near failure of American investment bank Bear Stearns has proved that no firm is immune. Even if there isn’t another high profile, near collapse in the coming months, there will no doubt be continued major write downs. Recently, write downs in the UK have lead to 8.6 billion pounds of net losses for foreign banks, the first deficit since 1998 and the worst on record. Even the consumer has shouldered the burden. With the credit freeze, the cost of lending has surged. Many major lenders and mortgage houses have announced they would raise rates – making official what the market has already essentially forced. These costs have essentially counteracted the Monetary Policy Committee’s efforts to loosen monetary policy with three rate cuts since December.
[B]Pound Struggling To Keep Its Yield Advantage [/B]
Up until the end of 2007, the British pound found much of its strength from its relatively high yield. Although the 5.75 percent benchmark rate was lower than its New Zealand and Australian counterparts, the sterling seemed to have greater fundamental viability as a carry trade candidate due to its position as a trade center, financial capital and economic powerhouse. However, in the past six months, the interest rate has acted more as a burden to the currency than a boon. One reason the yield has put the pound at a disadvantage is the prominence of the global credit crunch. With financial markets in turmoil, investors have looked to unload all their risky and highly leveraged trades. This in turn led to broad unwinding of carry trades that pulled the pound lower against most of its major counterparts. Given these circumstances it would stand to reason that the pound could rally if risk appetite revived demand for yield; however it may not be so easy for the British currency. Even if the carry trade regained its footing, the pound could continue to fall as the Bank of England leans towards cutting interest rates. Since December, the MPC has eased rates a cumulative 75 basis points despite ongoing concerns over upside inflation risks. The outlook for interest rates however is murky with producer price growth hitting a 17 year high. If the credit freeze thaws and growth stabilized, the policy authority could keep rates at a relatively elevated 5.00 percent. On the other hand, if conditions worsen or inflation concerns fade, the central bank could take to more aggressive cuts like the Fed and BoC.
[B]A New High in EURGBP[/B]
While the GBP/USD has spent much of the past quarter in a broad range, other pound crosses have seen far more dramatic moves. Among the most notable trends was the EURGBP’s steady rally to record highs. In fact, the pair was setting fresh all-time highs on a near daily basis during its more than 600-pip rise over the past three months. While some may attribute the pair’s progress to the euro’s strength alone, the pound’s weakness played just as much a role in the upside momentum. From a fundamental standpoint, the exchange rate draws a stark contrast between two currencies with dramatically different economic and interest rate outlooks. After three rate cuts, the BoE is expected to continue with its easing policy; and there is even speculation that the policy group will make more aggressive moves to offset impact of the financial crisis and cooling growth. In comparison, ECB President Trichet has repeatedly professed his concentration on upside inflation pressures and keeping rates at 4.00 percent since last June. Such a disparity between the two geographically close nations and the sharp weakness of the British pound against the Euro has helped to prevent a more major downturn in the UK economy and UK trade. While the country is looking at a potential housing collapse and the worst pace of economic growth since its last recession, policy officials have forecasted moderating yet steady growth for the Euro-Zone through medium term.
<strong style=""><u>GBP/USD Technical Outlook</em>
We wrote last quarter that “we expect a drop below 1.9755 and possibly a test of the 161.8% extension of 2.1160-2.0353/2.0831 at 1.9525 before a bounce. That bounce will clarify the overall pattern and provide us with our bias for months.” Wave structure on the daily is quite clear. The rally from the 2005 low (1.7047) subdivides nicely into a 5 wave impulse with wave 5 as an ending diagonal. 5 waves up should be followed by 3 waves down (and A-B-C correction). The decline from 2.1160 to 1.9337 was in 5 waves and serves as wave A of the correction. A corrective rally to 2.0396 was wave B and wave C is underway now towards 1.85. Corrections often reach the 4th wave of one less degree. In this case, that level is 1.8515. Wave C would equal wave A at 1.8572 and the 61.8% of 1.7047-2.1160 is 1.8618. In other words, 1.85/1.86 has a bull’s eye on it. An alternate count counts the decline from 2.0396 as wave X in a larger upward complex correction from 1.9337. Under this scenario, the GBPUSD would exceed 2.0396 before falling hard in the larger C wave towards 1.85.
