Hedging the Dollar's Rebound by Shorting the Pound

Summary:

For the purpose of this research report, I will explain why investors need to add a currency hedge position to their portfolio by short-selling the British pound currency ETFs. This is an investment hedge. This report is not a suggestion to make a large calculated trade as Soros most famously did so on September 16, 1992 How great was it to make a 1.1B return for one's firm and to have a "Black Wednesday" named after a trader?.

Detailed Analysis:

The purpose of shorting the pound was due to a macro-economic "top-down" analysis of the world markets. This research will illustrate why a strategy would be an effective means to guard against a rise in the U.S. dollar, and a drop in commodities.

I am entering a short position in the pound because I am becoming less negative on the U.S. dollar and U.S.-denominated assets relative to all other currencies. I am also becoming more negative on commodity prices, after its bullish run that began in March 2009 to the present. Even though the media continues to report that a global economic recovery is underway and will begin in Q4 2009, and that a recession "bottom" was reached recently or will be reached soon, I am unconvinced.

As a footnote, Teck Corp (TCK), for example, rose almost a fourfold. AA is up twofold. Gold and silver are both up at more reasonable levels (I am long on both to position the portfolio an inflation hedge). Oil is nearly double. Why should any of this matter in short-selling England?

A long U.S. Treasury (30-year), long USD and short pound are the players in my packaged hedge. I am essentially betting that the U.S. will continue to aggravate the world with its experimental quantitative easing. Therefore, the idea of higher interest rates, higher energy prices, and inflation are all symptoms of net-saving countries (China, Japan) trying to move away from the American currency. THAT is where the problem lies.

The net-saving nations are simply not in a position to cause inflation via higher commodities. They WANT their own currency to remain low, because that will improve net exports for these nations. If the U.S. currency remains depressed for too long, that imports inflation. As a result, the U.S. will WANT their currency to be stronger. Investors will seek the "least worst" of the options. Fundamentally speaking, the U.S. is in the least worst position if compared to England and Europe.

England and Europe (and the Euro) are both in poorer shape than that of the U.S. in economic terms. As the U.S. housing "crisis" moderates, this will not likely be the case for England. British banks and government figures have still not been quantified by the markets due to poor and incomplete reporting. Conversely, the U.S. "stress test" (I am still skeptical about just how stressful it is, due to assumptions used as inputs to its forecast model) added additional transparency to the U.S. banks.

It also worked.

Think about that for a moment: the relief rally resulting from this test enabled banks to raise capital from the markets, at a time when the credit markets were completely frozen.

Economic Analysis:

Look at this phrase reported by Reuters:

A weaker U.S. dollar helped push U.S. crude oil futures up more than $1 a barrel to top $71, a new seven-month high, after data Tuesday showed a steep drop in U.S. crude inventories, and lifted commodity prices like copper and gold.

Currency valuation is inter-connected to commodities. Commodity values are speculative and are based on incorrect forecasts for a resumption in global economic growth.

Let's say that the trend for an interest rates rise continues globally. London has no choice but to raise rates as well. The mortgage rise will reduces the sales of foreclosures and homes in general. Here's a headline that was published in London's papers Friday: "Nationwide hits buyers with mortgage rate rise."

Swap rates have also been rising. The net effect will be that the country may be paralyzed from taking any action to reduce rates for the purposes of stimulating demand for homes.

On the U.S. side, the situation is the same. So if two countries face the same economic challenges, which country do you put your money in? The question is that of relative strength, and that strength does not exist right now in the U.K. Let's analyze the fundamentals.

Fundamental Analysis:

Several points need to be made in my bearishness in Britain relative to the U.S.:

1. The housing market bust is substantial. This has greatly impacted the British Government's balance sheet. (see Markit’s services index regularly).
2. The question of government competence and collapse of support for the UK's Labour Party in the European election (as illustrated in the recent scandal and actions by the Prime Minister) will continue to destabilize the pound against the American dollar.
3. Economic fundamentals remain poor (some improvements were reported but one month does not justify a positive trend).
4. The cost for saving British banks has impacted the British government balance sheet significantly.
5. Quantitative easing (125 billion pounds) and the BoE interest rate cut (currently 0.5 percent) makes the pound unattractive as opposed to speculative headlines that the U.S. may have to raise interest rates.

Bank of England Forecast: UK GDP to fall by -3.4% for 2009. Source: MarketOracle

United States Forecast: Real GDP is forecast to contract by 3.2% in 2009. Source: Country Forecast at Economist.com

Comments: GDP forecasts are negative for both countries, but remember that British debt was downgraded. This has not yet happened to the debt for the U.S.

Portfolio Management:

To profit from this scenario, I am placing an incremental short position on the pound to 5%. I will increase my position to up to 10%. This short position will be balanced with LONG position on TLT (30-year U.S. Treasury).

Price Target:

My price target is $140-155. This is based on a target for the U.S. dollar strengthening by about 10% from current levels. The price target represents a 5% to 14% return from current levels. Combined with a TLT long position (and a target return of up to 15%), the net return on this trade is a maximum of 30%.

Conclusion:

I am not convinced that the 70% consumption rate is sustainable for the U.S. savings is up and will not fall to levels of the past. What this means is that the U.S. economy will suffer, but it will suffer less than other nations. The U.S. was the first to be more transparent and accountable (to a relative degree, of course). England did not take such a position. It is lagging in getting its house in order by at least a few months as compared to the U.S. Even though the Prime Minister "crisis" may put into question any rally for the sterling, the weakness on the sterling overall will be a result of the fundamental weaknesses discussed.

The way things may play out in the currency market is that funds will flow to the strongest nations. This needs to be accompanied by lower commodities, low interest rates, and a weak pound.

On the currency demand side, savers globally will look away from the weaker nations. England is on the top of this forecast list for weaker nations.

Risks:

Unexpected strength in U.K. housing, manufacturing/services, unexpected recovery from recession, and/or under-capitalization of U.S. Federal Reserve, continued weakness in the U.S. dollar. To mitigate portfolio loss, apply a stop loss of 10-15% on this position.

Disclosure: Author holds a SHORT position in FXB on a KaChing virtual portfolio (a site with over 370,000 registered users). This portfolio is also followed by nearly 400 users.

Comments

[tuj:]

"The net-saving nations are simply not in a position to cause inflation via higher commodities. They WANT their own currency to remain low, because that will improve net exports for these nations."

How do you explain the strength of the JPY? Surely BoJ must want to see the Yen above 100 to the USD if they want to keep selling cars in the US. BoJ could take steps to devalue but they haven't seemed inclined to yet. And yet Japan has taken some huge GDP hits. I don't understand it.

Jun 15 11:42 AM