Foreign Exchange - UK Weekly Update - Written by rick on Monday, April 27, 2009 15:17 - 0 Comments
The Long Road Ahead - World First - Sterling Update - 27th April
The Long Road Ahead
In 1997, Gordon Brown, the Chancellor at the time, made two commitments towards keeping national debt at sustainable levels. The first was to ensure that over an economic cycle the government borrows only to invest, and current spending will be met by taxation. The second was “that, as a proportion of national income, public debt will be held at a prudent and stable level over the economic cycle”. This was set at a rate of 40% of GDP.
While it is old news that this ‘Golden Rule’ has been broken, last week’s budget highlighted how dire the state of the public finances have become. The 40% level of the Golden Rule now looks like a speck in the rear view mirror, as the government revealed that it forecasts to borrow £175 billion this year alone, (more likely to be £200bn) to a level of near 80%, double the amount of the ‘Golden Rule’.
Wednesdays budget also forecasted economic growth for 2009 to contract by 3.5% (and a first quarter decline of 1.5%). It was immediately described by some economists as the “fantasy budget” after GDP data on Thursday revealed a contraction in the first quarter of 1.9%, the sharpest quarterly drop in 20 years. IMF Managing Director Dominique Strauss-Kahn suggested that the Chancellor may have forecasted growth rates that were overly optimistic, adding that “I would certainly have more pessimistic forecasts”. The IMF also pointed out that recessions associated with financial crises do tend to be more protracted than other types, and as a result forecast the UK economy to continue to contract by a nominal 0.4% in 2010.
The long term worry for sterling and the UK is that this rise in borrowing rises causes UK sovereign debt to be downgraded, increasing the cost of borrowing for the government and placing sterling in the risky asset basket. The Treasury itself stated it had no plans to bring its borrowing to more sustainable levels in the near term, only expecting the budget to be balanced by 2018. The IFS predicting that it will take until 2032 until the UK will again meet the golden rule standard of 40% of GDP. It will no doubt be a long road back to fiscal health, and hopefully not a long road to ruin.
The outcome of the budget plans and GDP result over the week was largely negative for sterling, causing the pound to slide against the euro by over 2%. The euro was also stronger on the back of some better than expected results from important leading indicators, the German IFO business climate index, and Euro Zone PMI readings that suggested the worst may be over for the single currency.
The dollar was impacted by Tim Geithner commenting that the vast majority of top US banks had sufficient capital to withstand the crisis, and that the TARP funds have around $135 billion still available. Equity markets responded strongly to this news and over the week managed to hold onto gains from the recent bull run. This helped to prop sterling up against the dollar, only losing 0.5% across the week.
The Bank of Canada and Sweden’s Riksbank were busy cutting rates throughout the week to 0.25% and 0.5% respectively. The Canadian Dollar was down immediately after the decision, as investors feared that the Bank of Canada would engage in QE at some point. These fears were later alleviated as it later stated it would adopt a “prudent” approach to monetary policy.
This week we have the RBNZ also looking to continue cutting rates, consensus is for a 50bp lowering of the official cash rate. There is plenty of upside risk for the decision as we expect that, like the Bank of Canada, Alan Bollard will make it clear that the RBNZ will not adopt any ‘unconventional measures’. There is plenty of conventional ammunition left, with interest rates at their current 3% level.
From the UK we have consumer confidence figures tomorrow, and the contentious nationwide house price index will look to clarify the state of the property market. The US provides GDP figures for Q1 on Wednesday, while Friday provides ISM manufacturing and factory orders
Trade of the Week
The trade of the week is relevant to a seller of sterling and a buyer of US dollars. This zero premium structure enabled the client to hedge their exposure for a three month period through a ‘window convertible forward’.
The client has a worst case rate (WCR) of 1.4250 and can benefit 100% of any and all upside up to a rate of 1.55 during the relevant window period. Should GBP/USD hit 1.55 at any point in the window period, the structure reverts to a forward contract at 1.4250. For full details of this structure please contact one of our options traders on 0207 801 9050.
Enjoy the week ahead
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