Yesterday, S&P, the ratings agency, summoned the confidence to speak out and say what the CDS markets have been telling us for a year, that the UK could lose its triple-A status. It lowered its outlook on Britain to "negative" from "stable" and conceded that the country faces a one in three chance of a ratings cut as debt approaches 100% of GDP.
That took the market by surprise and the pound dropped like a boxer caught by a sucker punch. Much to my surprise, it picked itself up off the canvas to win the fight. The chart below shows the exchange rate of the pound in dollars. Despite falling yesterday (black circle) on the S&P announcement, it has since recovered. As at noon today, the pound was trading 25 pips above the pre-announcement level!
Stiff upper lip - the British pound recovers despite new credit downgrade fears
Source: The BBC
Now, the announcement that the UK faces a potential downgrade does not surprise me. I have been warning of such a downgrade since 16 March this year and have been bearish on sterling since August last year. Nations with gross debt over 100% of GDP deserve to be downgraded. Indeed in 1995, Japan was stripped of its triple-A rating when it crossed the 100% threshold as did Canada when it crossed 100% in 1998.
What does surprise me however, is the market’s nonchalant response to a serious warning. After initially dipping, the pound has fully recovered. The consensus among the bulls seems to be that the pound is regaining lost ground having fallen so far in the last 12 months. That isn’t a good enough reason...
If we look at the key fundamentals of the currency markets - interest rates and relative value - neither are bullish for the pound. So the pound has no business in rising. It seems that currency traders are buying the same "green shoot" hype that the stock markets are. Against S&P’s warning, such optimism seems dangerously misplaced.
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