With the outbreak of the global financial crisis last year,
risk averse investors have been buying risk-haven currencies such
as USD and JPY against other major and emerging market currencies.
The British pound (GBP), which used to be a favorite carry trade
currency, plunged 26 percent against the U.S. dollar (USD) in
The decline of the GBP reflects the massive deterioration in UK
fundamentals following the global credit crisis and its heavy
reliance on financial services. The Organization for Economic
Co-operation and Development (OECD) forecasts the first British
recession in 20 years, which started in 2H 2008, will shrink the
economy 3.7 percent this year. The IMF also forecasts a 3.8 percent
contraction, making it among the hardest hit industrial countries.
Consumption, one of the main drivers of the UK economy, is
collapsing under the weight of the UK housing market collapse and
But so far this year, the GBP is more resilient than many people
thought. GBP has outperformed other currencies lately, gaining even
at times when the euro (EUR) was falling against the USD.
Year-to-date, the GBP is down only around 0.5 percent versus the
USD while the EUR is 7.6 percent lower against the USD.
Government policies have helped the GBP. The British government
was the first major country to deliver a 20 billion pound economic
support package last November. In addition, the Bank of England has
slashed interest rates to a record low of 0.5 percent and began an
unprecedented 75 billion pound quantitative easing program using
newly created money to buy assets. In comparison, the European
Central Bank is seen as behind the curve in its easing decision. It
was only last week that ECB President Jean-Claude Trichet promised
to launch some kind of easing policies without offering any details
on the plan.
Despite the government stimulus, the UK economy is facing its
worst recession in decades and may take several years to work
itself out. However, the outlook for the GBP is not that gloomy.
GBP has fallen far enough and its valuation now looks quite
attractive at current levels. While GBP still faces downside risk
in the near term, GBP finds support at recent trading range and
might stage a gradual recovery in the coming quarters, based on the
- The UK trade and current account deficit have already fallen
sharply for the past 12 months and will fall further. The weaker
GBP has helped to close the trade gap as British goods become more
attractive and boosted export. At the same time, a continued
decrease in income growth has led to weaker consumption, in turn
causing a fall in imports. With slowing growth and a depressed
currency, the UK's trade gap is poised to narrow even more in
coming quarters which is eventually positive to the GBP.
- Risk aversion remains a key theme in the currency market.
However, there are signs that risk aversion is subsiding. Tighter
spreads and falling market volatility in recent months supported
the gain in risk-seeking sentiment. The GBP benefits as risk
sentiment improved, resulting in GBP/USD surging to above the key
1.50 level last week. GBP will outperform as investors gradually
resume risk taking. Rising stock markets, positive surprises from
U.S. Q1 corporate earnings, have shown to help risk appetite.
Further improvements in risk taking sentiment in the coming months
will support GBP.
- The UK economy has shown some limited signs of recovery. House
prices in England and Wales continued to fall last month, but the
pace of decline was the slowest in a year. Sales volume picked up
from record low levels. Overall, the fact that the UK is taking
action much earlier in its downturn than most industrial countries
gives the Bank of England's policy higher odds of success. For
example, Britain has already launched a toxic debt scheme which
enables banks to offload the unquantifiable default risk on the
taxpayer in return for a fixed fee, giving the banks a clean slate
to calculate future lending. In contrast, the U.S. has still not
come out with a definite asset buying plan. The Japanese banks are
still hiding bad debts on their books years after the Bank of Japan
started quantitative easing. And as UK's macroeconomic data begins
to show signs of stability, stock investors are set to shift into
cyclical stocks from defensive plays which will help GBP.