Pundits predict more gloom for pound

The pound's biggest five-month rally in 24 years is ending as the Bank of England floods the shrinking UK economy with newly printed cash and slowing inflation precludes higher interest rates to lure investors.

The currency soared 23.5 per cent from March 10 to August 5 on speculation UK assets would rise as the worst financial crisis in six decades eased. The sharpest increase since 1985 ended on August 6 after policy makers said the recession was deeper than anticipated and moved to juice the economy by expanding its purchases of UK debt 40 per cent to US$290 billion ($433 billion).

Six days later, Mervyn King, Governor of the Bank of England, said inflation will probably fall below the Bank of England's target.

The pound has slumped 2.6 per cent since August 5 to last week's US$1.6543 close. Only three of 176 currencies tracked by Bloomberg did worse. BNP Paribas SA, France's largest bank, predicted another 9.3 per cent decline to US$1.50 in 12 months.

Bank of Tokyo-Mitsubishi UFJ said the currency is near a "tipping point". Just before the Bank of England decision, pound futures traders became as pessimistic as they were two weeks before March 10's eight-year closing low as weekly bets against sterling jumped 18.6 per cent, the most in a year.

"I'm super-bearish on the pound," said Hans-Guenter Redeker, the London-based global head of foreign-exchange strategy for BNP. "The Bank of England has made it clear it can't afford a stronger currency."

Weighing against the pound are attempts by Labour Party Prime Minister Gordon Brown and King to revive growth with increased borrowing, deficit spending and money printing. The UK will sell a record £220 billion ($539.65 billion) of debt in the year ending March 2010, the Government said on April 22, prompting Standard & Poor's a month later to warn that Britain may lose its AAA credit rating.

The UK economy shrank 5.6 per cent in the second quarter from a year ago, faring worse in the deepest global downturn since World War II than the US and the 16-country euro zone, which declined 3.9 per cent and 4.6 per cent, respectively.

Median estimates in Bloomberg economist surveys see the US shrinking 2.6 per cent in 2009 and expanding 2.2 per cent in 2010, compared with a 4.1 per cent contraction followed by 0.9 per cent growth in the UK. The euro economy will fall 4.3 per cent this year and rise 0.5 per cent next, survey medians predict.

Six days after the Bank of England ramped up its so-called quantitative-easing programme of debt purchases, the US Federal Reserve said it was winding down similar plans as it shifts focus from economic recovery to inflation control.

"The fundamentals in the UK are certainly not pretty," said John Taylor, who oversees US$9.5 billion as chief executive of FX Concepts LLC, a New York hedge fund.

"It's a race for the least ugly of the candidates, and I would argue that the US is going to be the least ugly for a while."

The pound is likely to strengthen no more than US5c before "getting crushed" in September, October and November to as low as US$1.45, Taylor said. The median prediction in a Bloomberg survey for the first quarter of 2010 fell US3c to US$1.64 per pound following the Bank of England announcement. The forecast rebounded back to US$1.67 on August 14.

Some investors are betting the pound rally will continue as measures by Brown, 58, and King, 61, ease the economic slump.

London-based HSBC, Europe's largest bank, predicts the currency will rise to US$1.75 by the end of 2010.

The housing market already shows signs of improvement.

Lloyds Banking Group's Halifax division on August 5 said UK home prices jumped 1.1 per cent last month, almost twice as much as the median forecast in a Bloomberg survey. Real estate agents and surveyors reporting price drops outnumbered those reporting gains by the smallest margin in two years, according to a poll released on August 11 by the Royal Institution of Chartered Surveyors.

The expansion of the quantitative-easing programme "seems like an insurance policy on the back of the weak second-quarter GDP numbers, and our view is for further appreciation" of the pound, said Paul Mackel, a director of currency strategy at HSBC in London. "The need for tightening monetary policy in the UK will become more apparent faster and that will become the pillar point for sterling to start re-establishing a more solid path versus the dollar."

Goldman Sachs Group said pound traders already have taken into account signs of recovery.

"After a sizeable appreciation, the pound has now priced in this improvement," analysts led by Dominic Wilson at the New York bank said in their monthly foreign-exchange report for July.

After spending most of the 1990s under US$1.70, the pound started to climb in mid-2001 as the Standard & Poor's 500 Index of US stocks plummeted following the crash in technology shares. From there, it mostly tracked the S&P 500, hitting a 27-year high of US$2.12 on November 9, 2007, a month after the stock gauge's record 1565.15 close.

The seizure of credit markets that had spread to the UK by early 2008 claimed its first victim that February when Brown was forced to nationalise Northern Rock after Britain's first run on a bank in more than a century.

The UK economy began shrinking the next quarter.

The pound topped US$2 for the last time on July 23, 2008, and tumbled after September's collapse of Lehman Brothers Holdings triggered the worst lending freeze since the Great Depression, pushing investors toward the perceived safety of the dollar. The pound closed at US$1.38 on March 10, the lowest level since June 12, 2001, down almost 35 per cent from its 2007 high.

That was the day after the S&P 500 began its steepest five-month climb since the 1930s, gaining more than 48 per cent as of August 14's close.

The subsequent pound rally lasted even as the UK economy shrank 2.4 per cent in the first quarter, the most since 1958, and 0.8 per cent in the second, twice the median of Bloomberg's survey of economists.

The number of unemployed Britons reached the highest level since 1995 in the second quarter.

With the next election now less than a year away, Labour has trailed the Conservative opposition in polls since 2007.

Then came the Bank of England's unexpected move on August 6 to increase its purchases of UK gilts by £50 billion to £175 billion, a move aimed at supporting debt prices to push down yields, the benchmarks for borrowing rates paid by businesses and consumers.

The UK's recession "appears to have been deeper than previously thought", the bank said. Six days later, King said it's "more likely than not" that inflation in Europe's second-largest economy will fall more than a percentage point below the bank's 2 per cent target.

That halted the pound's rally as investors increased bets that King wouldn't raise the central bank's benchmark interest rate next year from its record low of 0.5 per cent, where it has been since March 5.

Prices rose for futures contracts betting that the rate will remain flat in March 2010, reducing the yield to 1.18 per cent on August 14, the lowest level since at least March 2005 and down from 1.64 per cent the day before the Bank of England expanded its quantitative-easing programme.

As for the Fed's benchmark rate, near zero since December, futures on the Chicago Board of Trade show a 65 per cent chance the US central bank will raise it at least a quarter-point at its March 2010 meeting.

"The market was expecting the BOE to be one of the first to hike rates," said Lee Hardman, a currency economist at Bank of Tokyo-Mitsubishi in London. "It's becoming clear that's unlikely, undermining the pound."

In the week ended August 4, two days before the Bank of England's decision, hedge fund managers and other large speculators had 95,116 options and futures that profit if the pound weakens, known as short contracts, up 14,921 from the week before, data from the US Commodity Futures Trading Commission show. That's the sharpest increase since July 15, 2008.

With fewer long futures outstanding than short ones, the ratio of bets it will rise over wagers it will fall was 0.95, the most bearish since February 24, two weeks before the pound's March 10 low.

Goldman Sachs, which in May predicted the pound would gain 23 per cent against the dollar and 15 per cent against the euro by the end of the year, has lowered its forecasts, citing "worries about the fiscal outlook and the potential need to cut expenditure". The pound, which closed last week at 85.94p per euro, will trade at 84p from this year's third quarter of 2009 through to 2010's second quarter, the bank predicted.

Chancellor of the Exchequer Alistair Darling said on April 22 that this year's budget deficit would reach £175 billion, or 12.4 per cent of gross domestic product, the most since World War II.

Standard & Poor's, which has lowered its outlook on the UK's top AAA credit rating to "negative", said government debts could double to almost 100 per cent of GDP by 2013.

"Sterling is overpriced at current levels," said Geoff Kendrick, a currency strategist in London at UBS AG, listed by Euromoney Institutional Investor as the world's second-biggest currency trader.

"The BOE have made it clear they are more concerned about deflation, and it's possible they might do more quantitative easing," Kendrick said. "The economy is still soggy."

- BLOOMBERG