Simit Patel

First, there was Argentina. Then, there was Iceland.

And now the question everyone's asking: will Britain prove to be next?

Here's the chart of FXB, the ETF for pound sterling.


The situation is the same in Britain as in many other economies at the moment: a credit binge fueled an era of great consumption; excessively cheap credit, as institutionalized via monetary policy, resulted in malinvestments -- many of which occurred in the housing sector; and now, economies are faced with the question of how to deal with debt payments in a troubled economy.

From the perspective of Austrian economics, government can only transfer wealth/debt responsibility through the central banking system; it cannot actually create wealth (i.e. new stuff to buy). In an economy looking for real value -- i.e. an economy that is destroying credit, seeing a flight to safe assets -- deflation tightens the supply of credit and penalizes borrowers for being unable to make payments in a crisis. If inflation is the policy, lenders are penalized, as they will be paid back with a devalued currency.

Particularly, if foreigners are the lenders and are the primary owners of the wealth in the economy, inflation resulting in currency devaluation is particularly costly, as the exchange rate risk is more sharply felt. As a result, lenders who see inflation can begin a run on the currency. That is what happened in Argentina and Iceland.

Trading The Pound Sterling

The pound hasn't been this low in value since around the middle of 1995. At this point, I'd look to re-enter on a pullback. I refer back to the FXB chart posted earlier; a solid bear rally may emerge out of a test of the gap highlighted in the chart below.

Currency traders may wish to look at a short GBPJPY trade on a pullback.

Fundamentally, monetary policy is still inflationary; policymakers are still urging for a march to lower interest rates, noting that with rates currently at 1.5%, rates can still fall further.

The Counter-Argument

The TimesOnline offers a counter-argument, taking a few swipes at perma-bears like Jim Rogers who have been largely wrong in 2008 while celebrating the pound's liveliness. Personally, I view timing as the key issue; traders like Rogers are looking at a longer timeframe, where short-term reversals of the primary trend can last for a couple years.

Can It Happen in the States?

In my opinion, the strongest argument for why it can't happen in the United States is that the dollar is the world reserve currency, and thus there is "nowhere to run." Gold bugs, however, will cite gold as the place to run to, and will cite gold's longstanding purpose as guardian of sound monetary policy -- a viewpoint once espoused by Alan Greenspan, most notably in his 1966 essay, "Gold and Economic Freedom." It seems fitting, albeit ironic, that Greenspan's policies written as chairman of the Federal Reserve, may help us learn this lesson in a very real way.

To see if the United States is proceeding along the path to currency devaluation, we should look for a few indicators:

1. Nationalization of banks. Nationalization of banks will give the Federal Reserve even more control of the money supply, as it will empower the Fed to mandate consumer lending. We saw concerns of nationalization of British banks precede a sharp drop in the pound; this showed the market was concerned about the Bank of England's potential for more inflation/currency devaluation if there were greater centralization of monetary policy.
2. Purchase of corporate bonds. Likewise, we see this in Britain as well.
3. Strong inflation policy. Bank of England committee members are still arguing for the need for more inflation, and in the United States, the Federal Reserve is aggressively resorting to inflationary stimulus as well.
4. Treasury bonds give back all of their gains since October of 2008. Gilts, the bonds issued by the Bank of England (and thus represent the market's response to the debt burden), have recently given back much of their gains since October of 2008. Shorting long-term government bonds is a great trade for those who view a country's government as insolvent -- meaning the country will never be able to repay its debt.

Below is a chart showing Treasuries and Gilts since October of 2008.


Pound traders in particular will want to watch to see how the market responds to future rate cuts from the Bank of England. If rate cuts cause prices to fall, the market is more concerned about currency devaluation risk than about anything else, and thus is beginning the run. If rate cuts cause prices to rise, the market is responding normally, as bond prices are typically inversely correlated to yields, and thus rate cuts result in higher bond prices as they increase the value of existing bonds (except when currency devaluation is viewed as the greatest market concern).

In both the US and Britain, it will be worth watching how the market reacts to greater efforts at nationalization, which amounts to transfer of risk to government bond holders. Should demand for government bonds weaken in the face of increasing supply, we can begin to see bond market deflation, which should correlate to currency devaluation and the corresponding increase in prices of imported products and services.

Disclosure: Long gold.

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bains1971

Hi I wanted to ask what are the best option for the uk gov, do you think they have a advantage with Gordan Brown at the top seat, he has got a good track record. Oil is running out in the north sea, joining the euro is that an option?

UK has got a good track record for bouncing back.

Simit Patel

hey bains,

sorry for the late response. personally, i think the pound is still quite troubled, and i don't think gordon brown will helping the case. brown seems open to solving this crisis through a new currency agreement; perhaps the abandonment of the pound for a global or regional currency. in such a scenario, i think the pound would be devalued relative to other currencies it enters the new agreement with.

my $.02 for what it's worth.

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My Links: Proud to be a Permabear, Crisis Investing Video Series, Investing in a Centrally Planned Economy, The Investor 2.0 Quest