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By Jack Sparrow

Eighteen years ago, George Soros famously gained his reputation as “the man who broke the Bank of England.” In a bearish British pound trade conceived by the great Stan Druckenmiller, Soros’ Quantum Fund made more than a billion dollars in one day in 1992.

As expertly recounted by Sebastian Mallaby in “More Money Than God,” John Major and the hapless British government fought tooth and nail at the time to keep the pound from being devalued. It was a fight they ultimately lost to Soros and the “speculators” — and Britain was the better for it, given the strain exerted on the UK economy by an irrational commitment to the ERM (European Exchange Rate Mechanism).

Today, the British pound may be setting up for another excellent shorting opportunity — with an important twist. The government and the BOE (Bank of England) are not as likely to fight a sharp devaluation this time… and may in fact encourage it.

The reasoning has to do with Britain’s “radical” embrace of tight fiscal policy. The recent Economist cover pictured to right, depicting Prime Minister David Cameron as a rowdy punk rocker, captures the gist.

The article says that against an overwhelmingly Keynesian backdrop of economic orthodoxy, Britain’s willingness to slash spending, rein in the state, and overall ‘belt tighten’ is seen as a gamble:

As with all gambles, it could go wrong. The biggest danger is that fiscal tightening throttles the recovery: Mr Cameron may need a less hasty plan B…

…And opposition will grow. Teachers and doctors (many of whom supported Mr Clegg) seldom welcome change. In swathes of Britain, including Scotland, the state accounts for the bulk of the economy.

Last week, super-Keynesian Paul Krugman basically predicted this new round of belt-tightening would push Britain into recession or depression:

What happens now? Maybe Britain will get lucky, and something will come along to rescue the economy. But the best guess is that Britain in 2011 will look like Britain in 1931, or the United States in 1937, or Japan in 1997. That is, premature fiscal austerity will lead to a renewed economic slump. As always, those who refuse to learn from the past are doomed to repeat it.

And in response, the assistant editor of the Telegraph asked would someone please “shut Krugman up:”

Sorry, a bit late on this one, but I see old Kruggers, Nobel prize winner and New York Times columnist, is at it again…

…Maybe he’s right [in the prediction that austerity will lead to downturn]. Yet the idea that you can more or less indefinitely keep putting off deficit reduction until the economy is firing on all cylinders again just looks like an excuse to me for continuing to spend at unaffordable levels. He accuses the Tories of being “ideological” in their single minded pursuit of deficit reduction, and of using the crisis to dismantle the welfare state, yet he conveniently skirts around the underlying issue, which is in essence that the country can no longer afford this expenditure.

So what does this have to do with shorting the pound? Namely this:

In hard economic times, government has two levers of response: fiscal policy and monetary policy. They can loosen one, loosen the other, or loosen both. By embracing a “radical” program of tightened fiscal policy, the British government has removed one of its two key options, and thus all but guaranteed that looser monetary policy — i.e. “competitive devaluation” or “printing money” — may be required as a last ditch option to save the economy from renewed downturn.

For Britain, the deepest spending cuts in 60 years are coming even as a surprise fall in UK retail sales highlights the odds of a slump.

As Bloomberg reports in “Pound Set for Pain as Cuts Push King to Print Money” (emphasis mine):

Sterling has depreciated 5.1 percent against a basket of the nine other most-traded currencies, including last week’s 1.29 percent drop. Strategists are the most pessimistic on the pound versus the euro since the ruling Conservative-Liberal Democrat coalition came to power in May, according to data compiled by Bloomberg.

The decline suggests investors are losing confidence in Prime Minister David Cameron’s ability to restore growth while promising the deepest spending reductions in British history to shrink the biggest deficit in the Group of 20. His 81 billion pounds ($128 billion) of cuts through 2015 will force Bank of England Governor Mervyn King to print cash through so-called quantitative easing to prevent a new recession, overwhelming demand for sterling, according to UBS AG.

“There’s definitely more weakness to come,” said Hans- Guenter Redeker, global head of currency strategy in London at BNP Paribas SA. “The fiscal consolidation is going to hit the economy at a time when it’s slowing. Under these conditions, you need to have loose monetary conditions and that weakens the exchange rate.”

Redeker predicts sterling will drop to $1.40 by June.

From a technical perspective, the British pound chart looks attractive. This could be a trade with significant long-term potential.

It is notable too that, while US based exchange traded vehicles allow one to bet against the pound in USD terms, UBS is recommending British pound crosses against the Swiss franc, Aussie dollar and Norwegian krone.

Some other quick reasons to like a short pound trade in this general vicinity:

  • Potential trend change. A fall below recent lows would penetrate the 50 day EMA and represent a change in trend.
  • Potential USD rally. The USD is still heavily oversold as of this writing, with much of the dollar weakness rationale “priced in” via overwrought QE2 expectations.
  • Potential “risk off” trend shift. Again relating to QE2 hopes and dreams, the possibility remains of a dramatic shift to “risk off” posture in the near term. If this occurs, we can expect a potentially significant USD rally — and a commensurate decline in the major European currencies including the British pound.
  • Political "lock-in" to the fiscal austerity path. Again, the Cameron government is on a ‘no turning back’ path when it comes to tighter fiscal policy. This means Britain’s only true outlet for relief, in the event of renewed downturn, is an aggressive loosening of monetary policy.
  • The BOE is far more rational (read: ideologically flexible) than the ECB. The European Central Bank is, to a large degree, committed to hanging itself with an austerity noose by way of Germany’s deep-seated inflation fears. This in part comes from the fact that the PIIGs’ problems are not Germany’s problems, and thus Germany sees the world quite differently. The BOE is not inflation-scarred in such a manner, and in fact has institutional memory pointing in the opposite direction — towards the favorability of deliberate devaluation as a positive strategic decision. It was arguably Britain’s decision to bite the bullet and devalue (go off the gold standard) that saved it from even worse fiscal crisis in the Great Depression years, and again there is credible argument that the pound’s forced devaluation in the early 1990s, while deeply embarrassing the Major government, saved the U.K. economy from an unpalatable fate.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.

Source: Time to Short the British Pound?