Cameron Faith in Ratings That Don’t Matter Hurts Pound

U.K. Prime Minister David Cameron
David Cameron, U.K. prime minister. Photographer: Scott Eells/Bloomberg

The spending cuts that helped the U.K. preserve its AAA credit rating last year and bolstered the pound are now weighing on the currency as investors lose confidence that Prime Minister David Cameron will revive economic growth.

Sterling had its worst January since 2008 against a basket of nine developed-market peers, falling 0.6 percent, after a 3.1 percent advance in the second half of 2011, according to data compiled by Bloomberg. Gilts are lagging behind lower-rated Treasuries, after world-beating gains of almost 17 percent last year.

Investors are beginning to favor policies promoting growth over austerity just as the biggest government-spending squeeze since World War II risks sending the U.K. into its second recession since 2009. U.S. President Barack Obama has used outlays to drive America’s recovery even as near-record deficits led to an August downgrade by Standard & Poor’s.

“Given that there was no move from international bond investors to force this upon them, the U.K. is choosing a macro policy mix that is negative for the pound,” Mark McCormick, a New York-based currency strategist at Brown Brothers Harriman & Co. said in a Jan. 31 interview. “The main drag on the economy is the austerity measures taken to address the government deficit, which is meant to spur confidence in the bond market.”

Selling Gilts

Overseas investors sold a net 10.7 billion pounds ($16.9 billion) of gilts in December, the most since March 2009, Bank of England data on Jan. 31 showed. That was after the U.S. said net purchases of its financial assets by international investors soared to $59.8 billion in November from $8.3 billion in October.

The pound was little changed at $1.5821 at 12:55 p.m. New York time today, after falling as much as 0.5 percent. It strengthened 0.2 percent to 82.20 pence per euro. It’s down 0.8 percent this year, according to Bloomberg Correlation-Weighted Indexes, which track 10 developed-market currencies against each other. Gilts have lost 1.5 percent since December, including reinvested interest, while Treasuries lost 0.2 percent, based on indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies.

The combination of austerity and investor demand for a refuge from the euro-region’s sovereign debt crisis helped the pound appreciate 2.8 percent against the common currency in 2011.

‘Free Pass’

Sterling will end the year at $1.55 and 83 pence per euro, according to the median of no fewer than 40 analyst forecasts compiled by Bloomberg. Wells Fargo & Co., the most-accurate forecaster for the pound-dollar pair in the six quarters ended Dec. 31, according to Bloomberg Rankings, predicts sterling will drop to $1.54 by year-end, the data show.

“People are less willing to give the pound a free pass as a safe haven,” Todd Elmer, head of Group-of-10 foreign-exchange strategy for Asia excluding Japan at Citigroup Inc. in Singapore, said in an interview on Feb. 1. The “pound is in the middle to lower tier of currencies,” he said.

Eliminating the U.K. deficit, equal to 9 percent of gross domestic product, by 2017 has been the centerpiece of Cameron’s and Chancellor of the Exchequer George Osborne’s fiscal policy. By comparison, Obama is seeking re-election in November with a $1.3 trillion deficit, equivalent to 8.6 percent of GDP.

The U.K.’s top rating will probably not be enough to ensure demand for gilts and the pound, even as Osborne said on Oct. 3 that bond markets are “ready to pick off the next country that lacks the will to deal with its debts.”

S&P Downgrade

Deviation from the program would “be abandoning the deficit plan that has brought us the stability other nations today crave,” Osborne said then, the same day that S&P affirmed the nation’s rating.

The dollar outperformed all major currencies except the yen, while Treasury yields fell to records, after S&P cut the U.S.’s credit ranking one step to AA+ on Aug. 5. The ratings company, a unit of New York-based McGraw-Hill Cos., cited weakened “effectiveness, stability and predictability of American policy makers and political institutions” as reasons for the downgrade.

The U.S. currency rose 5.5 percent against the pound from the day of the cut through year-end.

“There is limited upside for the pound this year,” Brian Kim, a currency strategist at Royal Bank of Scotland Group Plc in Stamford, Connecticut, said Jan. 30 in an interview. “People are more comfortable with AA paper.”

Bond Yields

The extra yield investors demand to hold 10-year gilts versus similar-maturity Treasuries more than doubled to 0.256 percentage point this year through last week. The spread was at 0.6 percentage point, the most in more than two years, in September, about a month after the U.S. downgrade.

Yields on benchmark 10-year gilts climbed 11 basis points last week to 2.18 percent, while those for Treasuries of similar maturity increased 3 basis points to 1.92 percent. A basis point is 0.01 percentage point.

“We perceive their political will to be stronger than the United States to get their fiscal house in order,” John Chambers, managing director of sovereign ratings at S&P, said in a Bloomberg Radio interview Feb. 3, referring to the U.K. “Like the United States they have a reserve currency, and that gives them a lot of flexibility on the financing side. As long as they stick to that plan and maintain that credibility everything should be all right.”

A weaker pound may end up helping Britain. While exports fell 1.5 percent in November amid sputtering growth in Europe, the U.K.’s top export market, the goods-trade deficit narrowed by a record in October, fueled by demand elsewhere.

‘More Flexibility’

“The pound’s going to be a fantastic candidate for a new breed of safe haven,” Elizabeth Gregory, a market strategist at Swissquote Bank SA in Geneva, said in a Jan. 31 interview. Britain will “have much more flexibility than euro-zone counterparts to deal with their slowdown in growth,” she said.

Osborne has scope to implement “significant” fiscal stimulus to spur the economy amid signs that the deficit will be lower than estimated, an Institute for Fiscal Studies report said on Feb. 1. The report was produced with Oxford Economics, which predicts the economy will expand 0.3 percent this year.

The government’s deficit-reduction plan has helped restore confidence in the U.K. public finances and resulted in lower market interest rates, a spokesman for the Treasury, who declined to be identified, said on Feb. 2. This has allowed the Bank of England to keep monetary policy looser than it otherwise would have been, the spokesman said.

Quantitative Easing

The National Institute for Economic and Social Research said last week that it forecasts the U.K. economy will shrink 0.1 percent this year and grow 2.3 percent in 2013, compared with previous projections in October for growth of 0.8 percent and 2.6 percent. Growth in the U.S. may total 2.3 percent, according to the median estimate of 72 economists surveyed by Bloomberg News.

Unlike in the U.S., Bank of England Governor Mervyn King’s efforts to boost the economy through a bond-buying program may not be enough to prevent a contraction. The central bank’s balance sheet assets now total 19.8 percent of GDP, 0.7 percent more than the comparable ratio for the Federal Reserve, according to Guggenheim Partners LLC.

‘Moderately Bearish’

Bank of England policy maker Adam Posen said last week there is a case to expand the so-called quantitative-easing program by 75 billion pounds. The Monetary Policy Committee announces its next decision on Feb. 9. King raised the ceiling on the bank’s bond purchases to 275 billion pounds in October.

The cash being created by the Bank of England hasn’t spurred lending by financial institutions. The sterling Libor-OIS spread, a gauge of banks’ reluctance to lend, was at 58.8 basis points last week, approaching the widest since July 2009.

“In the short term, we are moderately bearish” on the pound versus the dollar, Callum Henderson, global head of foreign-exchange research in Singapore at Standard Chartered Plc, said in an e-mailed response to questions received on Feb. 2. “The likelihood that the Bank of England will enact even more QE should keep U.K. yields ultra-low, while the U.K. economy remains mired in recession near-term.”

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