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Suddenly, the British pound looks vulnerable

Bloomberg News | September 26, 2007
Gavin Finch and Bo Nielsen

Analysts at the world's three biggest currency traders advised investors at the start of the year to bet against the British pound. At the time, the currency traded at $1.9588. Instead of falling, the pound climbed to a 26-year high of $2.0654 on July 24, a gain of 5.4 percent.

But the analysts, at Deutsche Bank, UBS and Citigroup, may yet be vindicated, as the U.S. subprime mortgage contagion spreads around the globe.

Last week the pound fell to as low as $1.9881 after the Bank of England bailed out Northern Rock. The rescue of the mortgage bank brought concerns that more lenders might seek emergency funding and lead the central bank to cut interest rates, hurting the pound by reducing the relative attractiveness of British debt investments.

"This is an important turning point for the pound," said Jim McCormick, the London-based global head of currency strategy at Lehman Brothers, the largest U.S. underwriter of mortgage-backed bonds. "The expectations around the economy and monetary policy on the back of what has happened to Northern Rock have shifted pretty significantly."

Against the euro, the pound fell to a 17-month low of 70.053 pence last week. And the Bank of England's Sterling Effective Rate Index, measuring the pound against the currencies of 43 countries that trade with Britain, is at the lowest level in a year.

Deutsche Bank and UBS expect the pound to weaken 6 percent over the next three quarters. Citigroup anticipates a decline of about 1.5 percent by the end of the year. Strategists at the three firms predicted in December that it would trade at $1.96 or lower this year.

BNP Paribas, which said in June that the currency would trade at $1.88 by the end of the year, is even more bearish, predicting the pound will fall to $1.547 next year, while Lehman Brothers forecasts it will fall to $1.85 in 2008.

"The outlook for sterling took a turn for the worse after the Northern Rock crisis, which has undermined investor confidence in the housing market," said Hans Redeker, head of currency strategy at BNP in London. "Sterling is highly correlated to the housing market."

Record high delinquencies on mortgages to U.S. homeowners with poor credit have caused lenders around the world to push up borrowing costs and prompted the Federal Reserve to reduce rates last week for the first time in four years.

In Britain, soaring credit costs led Northern Rock, which relies on the capital markets for 73 percent of its funding needs, to seek emergency financing from the Bank of England this month.

As news of the mortgage lender's troubles spread, customers lined up at its branches to withdraw their savings, the first bank run in Britain since the 19th century.

Northern Rock shares have plummeted 70 percent since Sept. 13 in London, while competitors like Alliance & Leicester and Bradford & Bingley, which rely on financial markets for more than 50 percent of their mortgage funding, have also declined.

Mervyn King, the governor of the Bank of England, has defended his handling of the bailout. He told a parliamentary committee that British and European Union laws had hampered the central bank's ability to prevent the worst banking crisis since 1973.

"We've seen confidence in King erode," said David Watt, a senior currency strategist with Royal Bank of Canada in Toronto. "He hasn't handled the crisis well. If there's uncertainty about the decisions of the BOE, it erodes confidence in the pound."

Watt said Royal Bank, which predicts the pound will trade at $2.03 in the first quarter of 2008, planned to cut its forecast next month.

A decline in the financial industry, which accounts for 10 percent of British gross domestic product, could slow economic expansion in Britain. Growth may decelerate to 2.2 percent next year, the Confederation of British Industry said Sept. 20, compared with its previous forecast of 2.4 percent.

"The U.K. economy is one of the most sensitive to the ebb and flow of financial markets," said Kamal Sharma, a London-based currency strategist at Bank of America. "Any downturn in the global financial sector is going to hit the U.K. disproportionately hard."

The pound will fall to $1.91 by April, Sharma said, cutting his forecast for the currency from $1.95 on Sept. 17.

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