British Pound in for a Sharp Fall?

In my December 26 Money and Markets column I focused on the outlook for 2010, and the looming threats to global risk appetite. I warned that sovereign debt problems posed a major threat to global economic recovery. And I concluded that this threat represented a catalyst for a return of global risk aversion.

I also said that in a global crisis, these sovereign debt fears have the ability to be contagious. Such fears can destroy investor confidence in the capital markets of troubled countries, as well as in the overall global economy.

And when confidence wanes, capital flees … a surefire recipe for falling dominoes. That’s especially true in the wake of a deep global recession that has left many countries with bloated deficits and debt loads.

Despite the European leadership’s attempt to lessen the sense of urgency in the euro zone and despite the ambitious plans rolling out to shave outsized deficits, the problems with governments’ finances are not finding a resolution.

More likely, it’s just the beginning of another major destabilizing force for the global economy. And the result is looking more like another bout with recession … or perhaps depression.

Sovereign debt is setting the dominos up for a fall.

Here’s a brief look at how the dominos are setting up to fall, and ultimately why I think the British pound is the next vulnerable currency, as fear and instability spread from country to country.

Falling Domino #1:
Dubai, the Wakeup Call

In late November the Dubai government created a hiccup in the rosy plans that many market participants were increasingly hitching their wagons to: A V-shaped economic recovery.

All of the sudden the new, innovative center for global finance was in default. And contrary to what was assumed, its rich neighbors weren’t there to provide a lifeline.

Now Dubai World’s debt holders are getting only 60 cents on the dollar for their government bond investment.

Falling Domino #2:
Greece, Next in Line

Greece, the weakest of the sixteen-member European monetary union, the euro, was running a budget deficit more than four times the limits set forth in the euro-zone’s fiscal constraint guidelines.

The ratings agencies took the alert from Dubai. And they started slashing Greece’s sovereign debt ratings sending out a warning signal to all debt holders and making Greek government debt refinancing that much more difficult.

Falling Domino #3, #4 and #5:
Portugal, Ireland and Spain
The Next Troubled Spots

Greece isn’t the only euro-zone country in trouble … Portugal, Ireland and Spain all have severely bloated deficits and debt levels. That puts them in violation of European monetary union (Emu) guidelines, not to mention diminishes their outlook for economic growth — a tool desperately needed to start dealing with their red ink.

S&P stripped Spain of its AAA rating.

Consequently, the ratings agencies have put these weak countries under the magnifying glass. And ratings and outlooks have been downgraded. For example, Spain, the third largest economy in the euro zone, lost its AAA rating in January.

In prior Money and Markets columns I’ve discussed in more detail how the developments within these troubled Emu members have exposed structural flaws in the euro and have created an irreparable moral hazard.

Now, European leadership has stepped in and promised to provide support to the most immediate need: Greece.

By doing so it opens the floodgates. Meaning there is nothing to stop the other weak, fiscally-irresponsible members from lining up hat-in-hand to be bailed out by the stronger, more fiscally-responsible ones.

As for the euro, this total breakdown in the foundation of the currency union has it on a path for destruction or, at best, an extended period of uncertainty.

Falling Domino #6:
The UK, Looking Grim

The next, most vulnerable and biggest domino in line to fall is the UK. Among G-7 countries, the UK has the weakest performing economy, the largest deficit and the worst deterioration of its debt position.

As conditions get worse in the euro zone and it becomes increasingly evident that there are no clean fixes, the UK is the most likely candidate to come under the gun.

The pound is becoming more exposed to speculators.

The British pound plunged to its lowest level in 24 years against the dollar at the height of the financial crisis … now just a year later it appears another test of that level is in the cards.

And that’s where the outlook for the pound looks grim. Already, this week, negative forces have gathered against the pound taking it to its lowest level vs. the dollar in more than ten months!

So while the uncertainty about the UK government’s finances continues to build, I expect the pound to be the next victim of currency speculators.

Falling Domino #7:
The U.S.? In the Crosshairs

In this spread of sovereign debt fears, bond market pressures and falling dominos, the U.S. is in everyone’s crosshairs. And in a scenario where a sovereign debt crisis spreads through the major economies of the world and impacts some of the largest, most liquid currencies, the world doesn’t look like such a safe place any longer.

Therefore, if you’re evaluating your investment options, you’re likely seeking the highest probability for return of your capital rather than return on your capital. And I think the flow of global capital will demonstrate that the currency of choice will be the U.S. dollar and dollar-based assets.

Regards,

Bryan

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