Why It's Time to Pull Out of the Pound

The British pound has experienced a great run over the last month. It has gained an impressive 6.1% against the US dollar and has appreciated 11% against the euro since March. But all of that looks to come to an end.

With market volume and interest relatively nonexistent during summer months, and a lack of any real news events for now, investors are likely to focus solely on fundamentals – the forces that really run the country.

And let’s face it – the United Kingdom is in a rut. It’s literally teetering on the verge of a recession. Unemployment is relatively high, wages are down and consumer spending is thin. People aren’t spending enough to rev up economic recovery.

Of course, this is the case for major economies around the world. But a closer look at the United Kingdom shows the situation may be graver than we thought. Its fundamentals are still quite rotten – and government policies and banker infighting are making things even worse.

So while currency traders are overlooking these problems for now, they won’t for long. It’s only a matter of time before the British pound bulls are pulled down to earth.

That’s because two ingredients are vital for a healthy economic recovery: consumer spending and growing production. Every successful economy in the last five decades exhibited them. And they are largely absent in the United Kingdom today.

The British household savings ratio is at the lowest in about 40 years – just below 2%. But Britons aren’t spending that money on clothes, shoes or cars. They are spending their disposable income on higher gas and food prices. This lack of attention on anything other than necessities hurts retailers and other service providers. And that hurts the overall economy, since those services contribute 70% to the country’s overall gross domestic product.

But it doesn’t stop there. Lower consumer spending will hurt manufacturers – because less overall spending means less orders are being sent to factories to create goods.

And everyone knows, with less work, factories are inclined to lay off more workers. Cost cutting in firms throughout the country has contributed to a rising unemployment rate in the United Kingdom. At last check, it stood at 7.9% – well above its 5-6% average rate for most of the decade.

A country cannot rebuild itself if its foundations are weak. Without any real improvement in the underlying conditions in the United Kingdom, prospects for a full recovery remain dim.

And the British government is taking steps that will just make things even worse. In a healthy economy, the administration takes steps to boosts economic growth and optimism. It’s receptive to the idea of give and take – for instance, making reductions in transportation but boosting spending in education. Above all else, the government strives to balance programs without causing shockwaves in the market.

But Great Britain is doing the opposite – implementing tight and restrictive measures that run the risk of choking off early economic growth. The most egregious example from Prime Minister David Cameron’s austerity package is a raise in Britain’s value added tax (VAT). Similar to the US sales tax, the VAT is expected to rise from 17.5% to a rather expensive 20%. The new tax is likely to further decrease consumers’ desire to spend on anything other than necessities.

There are precedents of countries raising taxes during times of nascent economic growth. Each time the plan has backfired, pushing the country into a deeper predicament and punishing the home currency.

One of the most notable examples of this took place in 1997 Japan. With the Asian country showing early signs of growth after a recession, the administration – led by then-Prime Minister Ryutaro Hashimoto – decided to increase taxes. The move is still widely believed to be the principle reason for Japan’s prolonged recession. The yen lost almost 22% in the second half of the year following the tax hikes.

Currencies also suffer under political or monetary indecision. Until last month, the Bank of England’s Monetary Policy Committee stood unified against the financial crisis spreading throughout Europe. Inflation was low, and British policymakers were content with the way quantitative easing was being implemented.

However, with inflation now over 3% and on the rise, it seems that the bank has separated at two ends of the spectrum. Bank of England Governor Mervyn King wants rates low. But member-at-large Andrew Sentence wants higher rates to combat inflation. Although estimates are for rates to decline over the next two years, the indecision is sparking a bit of uneasiness in sterling markets. The longer this question goes unsettled, the higher the likelihood that holders of the British pound will lose patience with the bank’s indecision.

It is highly probable that the underlying British pound could retest one-year lows at this point. Without any real demand for the underlying currency – given the persistence of a deteriorating economic environment – the British pound has no real direction but down.

Richard Lee
for The Daily Reckoning