Forex Investment and Currency Trading

Sterling has been torched in recent weeks, and is nearly 20% down on its January 2007 peak. That is a similar fall, albeit slightly more drawn-out, than the 20% decline sterling suffered in the immediate aftermath of the decision to leave the ERM in 1992. Current economic events, and how they will impact the UK economy, are every bit as momentous as the ones of 1992 (far more so, indeed), but there is a crucial difference between the ignominious exit from the ERM as well as one really important similarity.

The UK is second only to the US in being close to the heart of this crisis - with a housing bubble a credit bubble and a big financial sector, all of which represented really good reasons to believe that the pound would get ‘carried out’ when the global carry trade ended. The economic outlook is dire (market expects real GDP to fall by 0.2% next year and rates to fall to 3 1.2%, at the very least). The
UK also has a large current account deficit (2.6% GDP). And really simply, with the highest policy rates in the G7, the UK always had the furthest for rates and the currency to fall of the major economies.

The big difference with 1992 however, is that this is not ONLY a UK event. A similar fall form grace as was experienced when the UK was ejected from a pegged exchange rate regime is a natural reaction, but an overshoot. Market is forecasting Euro-zone real GDP growth to be -0.2% in 2009, as well. Rates have fallen and will fall further, but the market has priced in both lower rates and rate convergence. In May, the spread between UK and Euro 2yr rates, 2yrs forwards, was 130bp. 10 days ago that had fallen to under 40bp and now, as the ECB gets moving and the European economy weakens, that spread has widened to 60bp. 5yr UK rates, 5yrs forwards, are BELOW Euro ones. Which is all a way of saying that a lot of the economic imact of this crisis is already ‘in the price;’ at least as far as rates is concerned. Indeed, if the huge cost of the UK bank bailout is felt anywhere, expect to see it in a renewed premium for UK longer-term forward rates relative to Euro ones. IE, 5y/5y rate spreads can move back in sterling’s favour.

The big similarity is that the UK authorities have, belatedly, excelled themselves. The critics that followed the collapse of Northern Rock is not being heard now. Broadly speaking, they have put in place the right package of measures, and been followed by the rest of the world. This is similar to 1992, when the exit from the ERM eventually proved to be a very good move, allowed the economy to be rebuilt and to thrive. This is the first recession since then. The markets took a while to realise that the exit from the ERM sowed the seeds of a 25% bounce by sterling. Maybe it will take a while this time too, but while bursting the credit bubble will be very painful, the policy reaction is appropriate and the bad news is being shared globally and is more priced in to sterling than elsewhere.