GBP Outlook

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Typically, sterling is one of the more volatile majors, but in 2011, trading in the pair was considerably more subdued; cable traded in a relatively narrow range of 1.55-1.65 as the euro and the Swiss franc commanded most of the market attention. This lack of limelight helped sterling maintain relative strength throughout the year. Some traders even argued that the pound deserved to be viewed as a safe haven currency, given the stability of its UK credit markets and the country's independent monetary policy. Yet in 2012, many of these assumptions may come under assault if the UK economy begins to weaken; then, the seeming strength of the currency may turn out to be a weakness if bond market vigilantes set their sights on UK bonds, making them the next target of the shorts.

Austerity and Growth Do Not Mix

In 2011, David Cameron's Tory-led coalition government made the unusual argument that the country's economy could maintain growth while at the same time instituting serious austerity measures to control the budget deficit. The UK's annual budget deficit had ballooned to 10% in the wake of the fallout from the financial crisis and Mr. Cameron's approach was initially viewed with enthusiasm by the market, which saw his proposals as the first substantive effort to control the burgeoning problem. A year later, the jury is still out as to whether Mr. Cameron's policy has been a success. In 2011, the UK Treasury ran a deficit for 10 out of 12 months with the total gap in the fiscal year through March forecast to be six billion pounds higher than the initially predicted at 128 billion pounds. Meanwhile, growth remains meager at best, with the UK economy expected to expand at a paltry 1% in 2011.

High Inflation Takes a Toll

In addition to its slow growth, the UK economy continues to suffer from the highest inflation rate in the industrialized world. In 2011, consumer price inflation peaked at 5.2% before easing to 4.8% by the end of the year. The high cost of living meant that UK consumers were constantly falling behind in real terms as wage growth averaged barely above 2%, effectively cutting incomes by nearly 3% on a year-over-year basis. Little wonder then that consumer confidence remained at multi-year lows, posting readings just below -30 for the better part of the year while retail sales contracted two out of the past five months.

Economy in 2012

As the UK enters the new year, its economy remains moribund, but bulls argue that several factors will help to stimulate growth next year. On the inflation front, the fading effect of the VAT increase and the need for producers to lower prices to accommodate lower demand could bring the CPI to a more tolerable 3% level. However, given the tensions in the Middle East and the persistently high prices in crude, such forecasts may be highly optimistic. The bulls are also looking forward to the London 2012 Olympics, which promises to boost tourism and consumer spending. Nonetheless, this effect is likely to be temporary and may be offset by the decline in investment spending after the games. Ultimately, the UK economy remains highly dependent on its financial services sector; given the turmoil in European credit markets, it seems more probable that UK financial firms will contract rather than grow in 2012, exacerbating the country's economic malaise.

UK: Isolated Politically

UK economic problems may be further aggravated by its iconoclastic political stance. At the most recent EU summit, UK Prime Minster David Cameron refused to accept proposed EU treaty amendments that called for greater fiscal coordination in the union. By standing apart, Mr. Cameron garnered the approval of voters back home, but managed to earn the ire of other European leaders who viewed his actions as nothing short of sabotage. As a result, the EU may now vote to enact a financial transactions tax in retribution for UK's actions - something that the City of London vehemently opposes. A financial transaction tax would prove disastrous to the financial sector of the UK economy; if imposed, it could trigger a significant selloff in the pound.

The Debt Nightmare Scenario

According to the McKinsey Global Institute, Britain's total debt, comprised of private, public, and financial sector borrowing, is the highest in the world. Official figures have put UK government debt at around £900 billion, which is equivalent to 60% of GDP. However, if the financial sector interventions are included, Britain's total debt figure reaches £2.24 trillion, or 147% of GDP. That ratio puts Britain on a par with Greece and Spain and makes its AAA rating highly suspect. Up to now, the UK has enjoyed relative calm in its credit markets. But if its sovereign debt comes under assault, it could face a nightmare scenario of high inflation and massive contraction as the costs of its debt service begin to rise. If UK debt faces a run by the shorts, much like the Club Med economies of Europe, the Bank of England will have no choice but to monetize the debt as the buyer of last resort. The irony of the situation is that while Germany remains fixated on the inflationary implications of an accommodative monetary policy, the true victim of high inflation could be the UK because it already carries the highest baseline price levels in the G-20 universe.

Conclusion

The UK economy spent most of 2011 under the radar, as focus in the currency markets was squarely on the Eurozone. Despite its attempts at austerity, the country was unable to make much progress at cutting its budget deficit and saw its growth slow to a crawl as cutbacks in public demand and problems in the financial markets weighed on performance. In 2012, the UK economy is unlikely to see much improvement as the persistent sovereign debt crisis on the continent will create further hardship for its vital financial sector and export growth. Throughout 2011, cable has been able to trade above the 1.5000 figure, but if UK debt markets begin to face pressure from speculators in 2012, that support level could crumble fast and the pair could see much greater volatility as its credit worthiness comes under question.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Forex and Currencies

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