Foreign Currency Markets - Sterling Collapse Against Dollar October 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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