Fundamental Outlook for British Pound: Bearish

- British Pound plummets as UK economy contracts by most since 1980
- UK remains especially vulnerable to financial stress as a major global hub
- Pound tumbles on Bank of England rate outlook

The British Pound was by far the worst-performing G10 currency through the past week of trade, as pronounced fears of UK government debt ratings and of domestic financial stability led traders to sell the GBP en masse. Speculators punished the British currency for what many perceived to be heightened GBP sensitivity to the ongoing global financial crisis, and overall fundamental outlook remains bleak. Indeed, the past week’s UK Gross Domestic Product report showed that the economy contracted at the fastest rate in nearly 30 years through Q4, 2008. Market reactions made it clear that few expect the government’s plans will substantially improve economic outlook, and the potential for sizeable government expenditures on stimulus packages actually worsened outlook for the British Pound.

Recent downgrades to Euro Zone member countries’ sovereign debt ratings sparked speculation that the UK could actually lose its coveted AAA rating—forcing a run on the British Pound and domestic government debt. Investors expressed clear concern that fast-growing government spending and far-reaching financial market bailouts could materially affect the state’s ability to repay debts. A closer inspection suggests that such fears are perhaps overblown, but the fact remains that UK government bond yields have jumped substantially on sovereign debt rating fears. (Bond prices move inversely to yields.) Both Moody’s and Standard & Poor’s debt rating agencies have reaffirmed the UK’s privileged debt status, but traders all the same sent UK asset prices lower on downgrade speculation.

Short-term outlook for the British Pound will subsequently depend on developments in financial market sentiment—especially as it relates to sovereign debt. Previous fears of corporate debt default are now compounded by similar fears for major governments, and that in and of itself highlights the depressed state of financial risk sentiment. Given such an environment, the highly risk sentiment-sensitive British Pound may have a difficult time regaining substantive ground against major counterparts. Yet extremely pronounced declines and overbearing GBP-bearish sentiment may soon reach a tipping point, and chances for a rebound have arguably increased. A relatively empty week of economic event risk gives us little to watch for, but keep a close eye on developments in UK financial markets and those abroad.

David Rodriguez is a Currency Analyst at FXCM.