London Bridge is Falling Down!

M6B1!

U.K. financial markets went into a freefall last week as Prime Minister Liz Truss announced aggressive income tax cuts amid deep fiscal trouble.

British pound is trading at $1.11 to USD, half of its value in 2007. However, it’s unfair to blame everything on a new PM and a new King. Both got their jobs just a month ago.

Sterling’s downfall started at the Bretton Woods in 1944, where US dollar replaced it as the default currency in international settlement. More recently, Brexit made UK weaker and less integrated into the global economy.

Let’s take a quick look at what happened in the last decade:

David Cameron (2010-2016)
• Mr. Cameron was reelected Prime Minister for a second 5-year term in May 2015
• To fulfill his campaign promise, he organized a referendum on June 23rd, 2016
• When asked if the UK should stay in the European Union, 51.9% of the voters said No
• On July 13th, 2016, Mr. Cameron resigned

Theresa May (2016-2019)
• Theresa May became the new Prime Minister after Mr. Cameron resigned
• In the following three years, she failed to negotiate exit terms with the EU
• On July 24, 2019, Theresa May resigned

Boris Johnson (2019-2022)
• Former London Mayor Boris Johnson replaced Theresa May as Prime Minister
• He engineered a hard Brexit in January 2020 without finalizing exit terms
• Johnson led UK government through global pandemic and Russia-Ukraine conflict
• On July 7, 2022, Boris Johnson announced his resignation

Liz Truss (September 6th, 2022 - Present)
• On September 23rd, Liz Truss announced the so-called “UK mini-budget”
• Key points: cut income tax from 20% to 19% and abolished a 45% higher tax rate
• New budget was received poorly by investors, causing market panic last week

When each of the Prime Ministers left office, they saw Sterling weaker than the day they assumed office: Cameron, from $1.7 to $1.3; May, from $1.3 to $1.2; Johnson, from $1.2 to $1.15; Truss, in less than a month, from $1.15 to $1.09 before rebounding to $1.11.

Where Will Sterling Go from Here?
Recent depreciation of Sterling can be explained by the Interest Rate Parity (IRP) theory.

IRP states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. It basically says that a country with higher interest rates would lead to a stronger currency.
• In 2022, the Fed raised interest rates five times for 300 basis points (bps), to 3.00%-3.25%
• In comparison, the Bank of England raised rates three times for 125 bps, to 2.25%
• European Central Bank raised rate only once for 75 bps, to 0.75%
• The Fed outruns the Bank of England and the ECB in both interest rate level and the frequency of rate hikes
• As prescribed by the IRP, aggressive Fed tightening results in a strong dollar, and weak Sterling and Euro

In the next year, I expect the pending global recession could result in a soft landing in the US, but hard landing in both the UK and the European continent.

In the long run, exchange rates reflect the relative strengths of two countries. The divorce of the UK from the EU makes them both weaker players on the world stage.

In 2021, the European Union had an aggregate GDP of $17.9 trillion, making the EU Block the 2nd largest economy in the world behind the US. However, after exclusion of UK’s $3.11 trillion GDP, the 27-nation EU would rank 3rd behind China.

UK ranks 5th, after the United States, China, Japan, and Germany. This is a far cry from the mighty British Empire which accounted for a quarter of the world economy in 1870. Today’s British Commonwealth is a loose network of countries with shared culture and history. None uses Sterling as legal currency except for the UK.

How to Trade a Bearish View in British Pound?
The next Fed rate-setting meeting is scheduled on November 1-2. October may be a calm month in terms of US monetary policy actions.

However, in a crisis mode, it’s quite possible for both the Truss administration and Bank of England to utter emergency measures to strength the British financial markets, with Pound Sterling included.

I would watch the British government actions closely in the next few weeks. We could wait for a rebound of Sterling before putting on the Short Futures trade.

CME Micro GBP/USD futures ( M6B1! ) has a notional value of £6,250. Initial margin is $255 per contract. December contract (M6BZ2) is currently quoted at $1.1172.

Barring a new "Lehman moment", the Fed would stay on its course to raise rates and fight inflation. I expect dollar to resume its rise against the Sterling in November and December.

On July 13th, my trade idea, The Demise of Euro Is Not Greatly Exaggerated, called for shorting the Euro. The Euro has since fallen a whopping 2% to $0.98 from on par with the dollar. My opinion on a bearish Euro 6E1! still holds today.

Financial market is extremely volatile this year. Getting an information edge increases your odds of success in managing risk. I suggest leveraging real-time market data for a better gauge of market situation. TradingView users already have access to delayed data. A Pro user could upgrade to real-time CME market data for only $4 a month, a huge discount at the time of high inflation.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.