The British pound has fallen to a 7-year low against the US dollar and a record low against the Japanese Yen. Over the past 3 trading days, the GBP/USD has dropped more than 1000 pips or 7 percent. Consumer prices were hotter than the market expected, so what has fueled this aggressively selling?

The market is afraid that the UK will turn into the next Spain or Greece. Over the past few months, they have been working overtime to inject more stimulus into the economy, but the more that they spend, the worse impact it has on the UK’s fiscal position. Deteriorating public finances has been the primary motivation for the recent downgrades of sovereign debt ratings by Standard and Poor’s. The FSA has dismissed this rumor but that doesn’t mean that the UK can’t be put on credit watch negative which would be one step before a downgrade. Investors are selling now and asking questions later because a downgrade would mean more losses for the British pound. Whenever a country loses its AAA rating, funds that are mandated to invest in only AAA assets need to liquidate and shift their positions elsewhere. We have seen this with Spain and could see it again with the UK.

Bank of England Governor Mervyn King will be speaking later today and he will probably attempt to calm the markets. But with employment data and the minutes from the latest monetary policy meeting due for release, his impact may be limited.

How Low Can the GBP/USD Fall?

The British pound has broken 2 key support levels - 1.45 and 1.40. Trends can last for a very long time in the currency market which is why there is a decent chance that we could see the GBP/USD slip to 1.3685, the June 2001 low. If that price level is broken, it would be a 16 year low for the currency pair. The 1.40 level is pretty critical on a closing basis. If the GBP/USD closes above 1.40 today, we may actually see a larger bounce, but don’t expect the currency pair to revisit the 1.45 level any time soon.

Canadian Interest Rates Could be Headed to US Levels

The Bank of Canada cut interest rates to 1.00 percent, the lowest level ever for the 75 year old central bank and signaled that they could bring interest rates down to US levels. The historic move was motivated by the sharp downturn in the US economy and the continual slide in oil prices. Not only are Canadians making less, but they are seeing their household wealth plummet as well. The Canadian economy is not expected to grow in 2009, which is why more rate cuts are needed. The BoC is far from done and could realistically match US rates. Inflation is not a problem since they consumer prices are expected to be negative for the next 2 quarters

The Canadian dollar has already sold off aggressively ahead of the Bank of Canada’s interest rate decision. It has stalled in the minutes after the announcement but should continue lower in the days to come.

Since the middle of 2007, the central bank has taken interest rates from 4.5 percent to 1.0 percent making the Canadian dollar the fourth lowest yielding G10 currency. The reason why the Bank of Canada needs to continue to aggressively stimulate the economy is because we are seeing a major slowdown in both the East and West. In the month of December, the unemployment rate rose to the highest level in close to 2 years. The IVEY PMI index of manufacturing activity hit a record low while Canada’s trade surplus fell to the lowest level in more than 10 years. Monday’s international transactions data indicated that foreigners were net sellers of Canadian investments for the fourth time in five months. According to Statistics Canada, the Canadian economy slipped into recession in the beginning of the fourth quarter and now growth is expected to contract by 1.2 percent in 2009. The Canadian government is very concerned that the recession will deepen in the coming months and they are probably right since oil prices have fallen 35 percent since December. Consumer spending within the country is just starting to contract as Retail Sales in October fell by the biggest amount in 2 years.

The big question is will the Bank of Canada take interest rates as low as the US? Since the US, Japan and Switzerland already have interest rates near zero, if Canada chose to “join the club,” it would not be out of ordinary. The economy is weakening so much that the Bank of Canada has its back against the wall and therefore we could realistically see 0.5 percent interest rates or lower in 2009.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.