Foreign Currency Markets – Sterling Collapse Against Dollar October 2008

by tradingrebel7B on October 28, 2008

Forex Trading – Is it really any surprise that the currency
markets have witnessed such a precipitous sell-off in Sterling
over the last few weeks? In just ten days, it sold off against
the US Dollar from 1.76 to 1.52.

I take a simple-minded view of fundamental analysis and firmly
believe that foreign exchange currency markets – or indeed stock,
bond or commodity markets for that matter – only trend so
dramatically in response to fundamentals when the latter are so
obvious that even your taxi driver can not only understand them,
but even express his/her opinion about them too.

We have precisely such a scenario going on in the forex markets
right now with this Sterling currency trend against the Dollar.

In order to avert total meltdown of the financial system, the
U.K. government has agreed to essentially be the lender of
last resort for all U.K. banks. They have effectively
nationalized the banks, and now stand as guarantor to a whole
ocean of shaky deals and fatally damaged transactions that even
they have no idea of the full extent of.

How do they plan to do this precisely? Where do they plan to get
the money from? In order to answer this, let us understand a
little-known but “fundamental” truth about governments: they
don’t make money! They are not businesses or entrepreneurial
ventures. They basically only generate revenue by taxing you and
me. When that fails, the only other way that governments “make
money” is to literally make it; in other words, they print it!

So, while the U.K. government has attempted to halt the
catastrophic slide in banking sector shares specifically, and the
U.K. financial markets in general, it has essentially done so by
playing Poker with the currency markets, hoping that nobody can
see behind their confident-looking phony smiles and see their
real hand. Yet, when their hand is called, it consists of only
twos and threes.

In other words, it is blatantly obvious to forex traders
worldwide that the U.K. government has no leg to stand upon. They
can only pay for their enormous bailout plan by printing money.
Otherwise, where is the money to come from? It will certainly not
come directly from the tax payer in terms of a rise in taxes.
Apart from the huge resentment nationwide against the very idea
of bailing out big business with tax payers’ money, it is
doubtful if even this strategy would be enough to pay the
enormous sums involved.

Let us also remember that the banks are not necessarily the end
of the financial crisis. What about the UK pension funds that are
also suffering from the worldwide stock market crash? If the U.K.
government has rescued the banks, it is surely only a matter of
time before they are obliged to step in to defend the pensions of
those long-suffering U.K. citizens as well. How can they rescue
the banks but let the pension companies fail? The cost of this
latter bailout will also run into the hundreds of billions.

Hence, the currency markets know that the U.K. government can
ONLY respond by essentially printing money. If more money
is printed, it means more bank notes in circulation that are
backed by nothing more than words; fine promises from a
government that is at risk of rapidly bankrupting itself and the
nation in a desperate attempt to save the latter from the most
obvious form of ruin.

Hence, the currency is automatically devalued by this process,
and the foreign exchange markets have reflected this obvious
logic by rapidly “re-pricing” sterling to reflect what the future
must surely hold.

Now, I have heard more complex explanations of why Sterling has
sold off, but although it is interesting, it does not maintain
the “common sense” theory of fundamentals that I believe must be
present in order to trigger a massive sell-off such as we saw.
One such argument goes like this…

The major banks all borrowed many billions of dollars to fund
their sub-prime mortgage deals. The figure may run to a trillion
dollars or more. Of course, these dollars still have to be paid
back, even though the underlying assets are effectively dead.
Since you have to buy them back, the question is, from whom?
Answer: all the other banks that are also trying to buy them to
cover their own losses.  So, in order to protect themselves,
these banks then withdraw from the market making. Thus, a one way
illiquid market results.

Maybe there is  truth to the latter theory, and it
may underlie the thinking of some of the players. However, I
would contend that these theories are the very sort of
fundamental that can lie festering for ages and do NOT give rise
to short sharp shocks of the kind we see in the forex
Sterling/Dollar market at present. For a Sterling sell-off from
1.76 to 1.52 in just ten days, there has to be an enormous
common-sense consensus that would drive all players to act
simultaneously. Foreign currency traders as a herd are not so
smart as to all hold the complexities of the latter theory in
their heads simultaneously.

In the forex collapse we see in sterling against the dollar,
what we probably have is the U.K. government being caught
red-handed with its pants down; an “emperor with no clothes”
syndrome. You simply do not have to be a genius to understand
this. When you have no money, how do you make promises to pay for
things you cannot afford? You either borrow the money or you
print it.

Borrowing money in the enormous quantities required can only have
the effect of demoting the U.K. Gilt securities close to the
status of junk bonds since, once again, everyone will know that
the borrowings are not being made to the U.K. government per se,
but rather to fund huge unspecified junk loans resulting from the
bailout of the banks and all the junk debt on their books. In
other words, a flood of new U.K. government bonds are issued, but
this time blatantly lacking the “quality” that you would expect
from government debt since everyone knows the real reason for the
borrowing; to fund a bottomless pit of junk debt.

It would not surprise me to see Sterling remain depressed against
the Dollar, and not recover its traditional median value
of 1.75 or so, for some considerable time to come. This is a
re-pricing that did not come out of the blue. Rather, it is the
result of eminently good sense.

When there is an excess supply of any commodity, its value and
the demand for it goes down. That is the simple law of supply and
demand. In this instance, the commodity in question is…

Pound Notes!

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