The drop in the GBP/USD this week has been nothing short of astonishing. The pair erased more than 1000 points off its price with streling depreciating by more than 6% against the dollar. Although cable has been in decline since the turbulent markets of last fall, this latest freefall carries a whiff of true panic about it as markets fear that that UK government spending schemes to rescue the country’s ailing banking sector will put unsustainable stress on the Treasury.

The run on the pound was triggered by Prime Minister Brown’s latest proposal to spend an additional 50 billion GBP to insure toxic assets of the banks, as well as by the RBS revelation of the largest loss in UK corporate history. Those two events have greatly damaged the markets confidence in UK financial system, sending sterling plummeting as traders question the UK government’s ability to successfully float so much fresh public debt as 2009 unfolds.

The collapse of global capital markets turned the UK economy from boom to a bust in a blink of an eye. Despite inflation levels that remain above 3% the BoE has lowered rates from 5.25% to 1.5% in less than 12 months as UK unemployment rolls swelled to 6.1% and UK finance sector reeled from record losses on credit instruments. Looking forward, there is little hope on the economic horizon. The unbalanced situation of the UK economy persists and should global equities remain in a protracted bear market, the long term damage is likely to be severe.

The BoE policy is relying on the assumption that lower currency values will address some of those imbalances, but so far that thesis has failed as the country’s Trade deficit continues to swell. UK may now face a true nightmare as the economy continues to contract, but inflation levels rise due to the weakness of the currency and the UK government’s inability to raise new capital at reasonable interest rates.

While the events of the past few days have certainly punched the pound in the solar plexus, the currency of another Anglo-Saxon economy just across the Atlantic has remained strong and steady. Nevertheless, while the greenback may appear to be a rock of stability amidst the chaos of the currency markets, the pound saga may serve as a cautionary tale for greenback longs.

The very same reasons that felled sterling this week, may also bring down the dollar. Much like the UK economy, the US economy has relied on the financial sector for the majority of its recent economic growth. At its height the US financial sector represented more than 20% of the S&P but the double collapse of US real estate and equity markets have wiped $10 Trillion off household net worth bringing consumer spending to a standstill. With the consumer representing 70% of the US economy this sharp contraction in demand brought all economic growth to a virtual halt.

Up to now the dollar has ignored this negative economic backdrop as global capital flows have continued to pour into the safety of US Treasuries, driving the yield on four week T-bills to practically zero. Yet the critical question facing the currency market in 2009 is how long will global investors give US a free ride on their money?

One of the primary suppliers of capital to the US is China and recent capital inflow data indicates that the Chinese have shifted the vast majority of their investment portfolio away from Agency bonds (such as Fannie Mae and Freddie Mac) towards Treasury securities. In other words US now finds itself in a precarious position where a significant portion of its debt resides in short term obligations subject to rollover risk. Should the Chinese lose faith in the “full faith and credit” of the United States the downside pressure on the dollar could be enormous as capital flight will surely ensue.

To aggravate the situation further, the current stimulus plans of the Obama administration are likely to add an additional $1 Trillion of spending at a time when tax revenues are falling off a cliff. The dangerous combination of record new spending and near total reliance on foreign capital to finance such spending creates the primary risk to the dollar this year. While, the chance of an immediate global run on the greenback appears to be relatively small, since the unit continues to serve as the reserve currency to the world offering the best choice amongst many unpleasant alternatives, currency traders should not be complacent. The vicious run on the pound stands as a stark reminder of how quickly sentiment can change in the FX market. With so much debt outstanding and so much more to be issued, the dollar could indeed become the next “pound” in the currency market and traders should prepare accordingly.

Boris Schlossberg serves as director of currency research at GFT, and runs bktraderfx.com.