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Moody's dropped a bomb on the British pound half an hour before U.S. markets closed for trading on Friday. For the first time ever, a rating agency stripped the U.K. of its prized AAA rating. When the news broke, many economists argued that the decision by Moody's was expected and will not have a meaningful impact on the currency but based on the reaction that we have seen so far, FX traders are not acting as nonchalantly as the "experts" predicted. In the long term, these economists could be right in that the downgrade will not cause investors to abandon U.K. stocks and bonds but in the short term we could see the GBP/USD break 1.50 and maybe even test 1.45.

How the U.K. Downgrade is Different from the U.S. Downgrade

The main reason why experts say that the U.K. downgrade doesn't matter is because the markets took the U.S. downgrade in stride but not before some immediate pain for the dollar and an 8% slide in the S&P. The U.S. survived its downgrade in August 2011 because U.S. Treasuries are viewed as the safest investments in the world. U.K. Gilts are also considered safe investments because the chance of the U.K. defaulting on its bonds is about as slim as the chance of the U.S. defaulting. However fewer investors consider Gilts as a safe haven like they do Treasuries. Also leading up to the U.S. downgrade, there was a lot of talk about the possibility, giving investors plenty of time to adjust their positioning. While there have been some murmurings about a U.K. downgrade, most investors have been focused on the short JPY and short EUR trades in anticipation of more BoJ easing and greater risks in the Eurozone that they may not have gotten into the short GBP trade.

We can see this through IMM positioning. Before the U.S. downgrade (see chart below), short USD/JPY positions were not far from its 20 year high. Before the U.K. downgrade, IMM data showed short GBP/USD positions at only a 1 year low and far from historically extreme levels. This confirms that fewer traders anticipated the move and could therefore join the selling next week.

Dollar Still Fell 300 Pips After U.S. Downgrade

Even when the U.S. was downgraded, the dollar fell 3.8% in the 4 days that followed while the EUR/USD fell 2.5%. The following chart shows how USD/JPY behaved after the downgrade, which came a day after BoJ intervention. While the sell-off in the dollar against the JPY and EUR were modest for investors, on a short-term basis, the dollar dropped in excess of 300 pips, which isn't minor for most traders. The GBP/USD has already fallen 300 pips from its pre-downgrade levels but since because fewer traders were short sterling before the announcement, we could see a stronger sell-off in the pair before it finally stabilizes.

But Impact on Bond Yields Should be Limited

When it comes to downgrades, what the market is most worried about is the impact on borrowing costs and from this perspective, we believe that the experts are right and the impact on yields should be limited. According to a study conducted by Bloomberg, "yields on sovereign securities moved in the opposite direction from what ratings suggested in 53% of 32 upgrades that happened last year. Investors ignored 56% of Moody's rating and outlook changes." While Fitch or Standard & Poor's could downgrade the U.K. as well, they will most likely wait until the Budget in March. In all likelihood, because of this downgrade, Chancellor Osborne may have to squeeze the budget further and if he has to push out his timeline for meeting his budget target in March, the other two rating agencies could take action.

According to Moody's, the main driver of their decision "to downgrade the U.K.'s government bond rating to AA1 is the increasing clarity that, despite considerable structural economic strengths, the UK's economic growth will remain sluggish over the next few years due to the anticipated slow growth of the global economy and the drag on the U.K. economy." Recent U.K. economic reports confirm that the recovery is losing momentum. Retail sales fell in January, showing a weak start to the year for consumer spending. In fact, consumption failed to increase for the past 4 months and conditions are so worrisome that Bank of England Governor King voted with the minority this month in favor of more Quantitative Easing. Therefore Moody's concerns about economic growth are well placed and if the U.K. government wants to reverse this trend, one way would be to encourage the BoE to provide a greater cushion for the U.K. economy by increasing monetary stimulus. As a last resort the U.K. could print more money to finance its debt, which would not be positive for the GBP.

GBP - How Low Can it Go?

Moody's decision to downgrade the U.K.'s sovereign debt rating only added to the growing numbers of reasons for why the GBP should remain under pressure. Aside from weaker economic data, BoE Governor Mervyn King joined the chorus of central banks voting in favor of more Quantitative Easing. Over the last 6 years, King voted with the minority only 3 times and 2 of those times, monetary policy was changed in the way the minority favored within 3 months. This is hardly statistically significant but nonetheless interesting and few will argue that the U.K. economy needs more help. Fundamentally, we believe that the GBP/USD could fall at least another 2 to 3%. Technically, the GBP/USD has broken its 2.5 year range low. The psychologically significant 1.50 level could serve as near term support but the March 2010 and May 2009 low of 1.4755-85 appear to be a more important level. However traders should also be mindful of the fact that the GBP/USD is a very volatile currency pair that can experience large intraday swings. Hourly charts show a gap on Sunday at 1.5160 and if the gap is filled, we could see a strong rally to 1.52 but near term gains should be capped at that level.

Source: How U.K. And U.S. Downgrades Are Different