The Bearish Case for Sterling

Sterling has been resilient today in the face of the Fitch warnings of the UK's rating vulnerability and the deterioration on the trade front. Supporting it has been reports suggesting that Norway's petroleum fund is looking favorable at some UK property investments and M&A related activity. There are of course some large investment houses that have identified sterling as a beneficiary of the generalized recovery.

We are more comfortable with the sterling bears. The bearish case is well known, underscored by Fitch's comments today and last week's indication that of the major central banks the BOE is the only one to extend QE, whereas others are talking in varying degrees the conditions of exits.

One interesting development relates to positioning. As of the middle of October, noncommercial (speculators) had a record short sterling position of 65.3k contracts. As of last Tuesday, the bulk of the positions had been covered and the next short position was just shy of 19k, smaller than the 26 week average (-20k) and 52 week average (-26.3k). The price action since last Tuesday, lower volume in the front month contract and open interest appears to be increasing (+5%), suggesting the while there is some churning, it is possible the bears are trying to re-establish shorts.

A consideration that seems to be lost on many is that the total dollar value of the assets at the top five banks stood around $4.8 trillion at the end of Q1. The UK's GDP is only $2.6 trillion. To put this in perspective, consider that the assets of the top 5 US banks was valued at about $5.3 trillion with US GDP of $14.2 trillion. This is another way to illustrate how much more vulnerable the UK is to a draw down in asset values.

UK survey data has been reported more favorable than the contraction of Q3 GDP reflected. Ideas that Q3 GDP could be revised higher were dealt a blow by today's wider than expected Sept trade deficit.

Tomorrow the UK reports their latest labor market data and further deterioration is expected and this is likely to be reflected in weak employee earnings data. However the BOE's quarterly inflation report may receive greater attention.

The BOE is required to base its projections on the government's fiscal policies. These currently call for halving the deficit to 6.2%. While this seems difficult to achieve, the rating agencies seem to be demanding even more dramatic action. Fitch affirmed its ratings despite today's warning, while S&P has the outlook negative. It appears next year's election is the key event for the rating agencies.

If fiscal policy is to be less supportive than the current government is projecting, then its forecasts tomorrow may be for greater inflation and more growth than what may actually materialize. In addition, dramatic tightening of fiscal policy will likely force the BOE to be more accommodative. That policy mix of tighter fiscal policy and loose monetary policy tends to be associated with a weakening currency.