During the last six weeks, the British Pound Sterling has taken over the dollar’s role as the whipping boy of the currency markets. Since touching an eye-popping $2.11 in November, the British Pound Sterling has dropped more than 7% and fallen through the $1.96 level this past week. Here’s why I think the British currency is set to fall at least another 15% during the next three to six months.
First, the negative news coming from the United Kingdom during the past few weeks has been relentless. Economic growth seems likely to slow sharply, short-term interest rates are set to fall and capital markets are suffering credit-crunch blues. And while subprime woes are grabbing headlines in the United States, the United Kingdom’s position is by almost all measures worse than that of the United States. The run-up in U.K. house prices was much bigger and housing valuations and household indebtedness are still more extreme than in the U.S. market. At the end of 2006, U.K. household mortgage debt was 126% of GDP, against a mere 104% in the United States. The United Kingdom’s current account deficit, at 5.7% of GDP in the third quarter of 2007, also was bigger than that of the United States. Indeed, some experts estimate that the United Kingdom’s true current account deficit is actually closer to 7% of GDP.
Second, the British Pound Sterling is probably the most overvalued currency in the world. As any of you who have traveled to London in the past few years can confirm, $1.96 buys far more in the United States than £1 does in the United Kingdom. Morgan Stanley estimates that in purchasing parity terms, the British Pound Sterling should be trading at around $1.64 to the dollar — just about the average dollar exchange rate since 1985. Bank of New York Mellon notes that the British Pound Sterling is almost 18% above long-term averages compared with the dollar. In fact, BNP Paribas points out that the British Pound Sterling is now more overvalued than it was on that fateful day in September 1992 when George Soros made his $1 billion bet.
Third, once the bottom drops out of a currency, it tends to overshoot, both on the upside and the downside. In the last few weeks, the British Pound Sterling has fallen like a warm knife through butter. Not even the Bank of England’s decision to keep U.K. interest rates on hold at 5.5% last Thursday could steady its free fall.
So sell the CurrencyShares British Pound Sterling Trust (FXB) at market, and set your stop (buyback price) at $205. Note that currencies generally are much less volatile than any stock. That means that you can probably take 2x or even 3x your normal position size. But because FXB is such a low volatility play, you won’t get the kind of potential returns from the options you would get on stocks. But if you do want to play the options, I recommend the June $197 Put Option (FXBRO.X).
To make room for this week’s relatively low-risk, low-volatility bet, sell your position in Turkcell (TKC) at a loss. This sale is part of the shift away from holdings that are highly correlated to global equity markets. I’m reluctant to close out the rest of the portfolio’s positions in some challenging markets because I know how quickly these positions can soar on a change in market sentiment. Meanwhile, tighten your stop in Vimpel-Communications (VIP) to $34.50 and Mechel (MTL) to $83.50.