Tea Time! Oh wait…

All this political mumbo jumbo has given the pound a headache. One minute it’s soaring in the sky, and the next minute it’s jumping off the cliff into the English Channel. Where is the pound really heading? Will it rise to levels prior to the recession? Or will the political turmoil drag the pound down along with it?

Last week, like rats deserting a sinking ship, eleven government ministers have stepped down from their posts, leaving UK on the verge of a political meltBrown -err, meltdown. A scandal over some parliament members’ excessive expenses on cookies, horse manure, swimming pool and tennis court repairs (quite an unusual bunch) has enraged the public and the opposing Conservative party. Prime Minister Gordon Brown, who once promised he’d lead the world out of the economic crisis, is now painting the image of a government in chaos. With the Conservatives clamoring for a snap general election, Brown is holding on for dear life to his post. He announced that he will be throwing out the skeletons in the closet as he reshuffles his Cabinet.

Brown managed to take a breather as he survived unscathed from the Labour party rebellion a few days ago but this political calm is only for the time being. The current Prime Minister still has to contend with the possibility of lower Labour approval ratings that could be grounds for a re-election. Oh bloody hell.

Aside from the political landscape, it is also hard to ignore the recent statement made by ratings agency Standard & Poor’s (S&P), which has revised its outlook on the UK’s sovereign credit rating from “stable” to “negative”. The agency feared that the country’s ballooning deficits has now reached extreme levels and said that the government is failing to recognize its rapidly deteriorating public finances. The UK’s public debt now stands at 70% of its GDP! Furthermore, UK’s economy is expected to contract 3.2% by the end of 2009. S&P warned that if the government does not take measures to reduce the scale of its public debt, the previously prized ‘AAA’ credit rating (highest possible level) would simply be a thing of the past.

A growing budget deficit is like cancer. Slowly but surely, it eats up the country from inside by spreading throughout all sectors of the economy. You see, as the government’s deficits continue to grow, taxes too must rise at the same pace in order to pay them off. It’s not that easy to simply “raise taxes.” Remember that the world, not only UK, is in a state of protracted recession. Growth is stunted, resulting in lower tax revenues because of contracted economic activity, which trickles down all the way to the common man – the taxpayer. If taxes are increased, economic activity slows down, which, in turn, would further worsen the already deteriorated economy. On the other hand, if taxes remain the same and deficits continue to balloon, UK’s creditworthiness would be questioned. This would mean that the cost of government to borrow would be pushed up, which could mean higher interest rates across the country. Aye, there’s the rub!

But wait, there’s more!

The Bank of England (BOE) decided to keep its target interest rate unchanged for the third time this June at an all-time low of 0.5%. Keep note that the rate has been cut all the way from a high of 5.0% last seen in October of last year. The bank’s monetary policy committee also resolved to maintain its £125 billion asset buying program. Under this program, the BOE prints new money to purchase government and corporate debt. The purpose of this move is to increase the money supply and promote economic activity by encouraging banks to lend more. This ongoing program is expected to conclude in July.

These policies normally (notice the bold/underline/italicized effect) dilute the value of a currency. First, interest rate cuts make UK investments less attractive because of lower yields. Secondly, quantitative easing measures make a currency worth less (not worthless, mind you). To illustrate, it’s like simple supply and demand – higher supply, naturally, will result in a lower price since there is more of product at hand.

Thing is, the pound, like other currencies, seems to be purely driven by degrees in risk appetite. Upon the release of the possible S&P credit downgrade, the GBPUSD dropped 200 pips – only for traders to see it is as another opportunity to buy up the pound! Last week, when the political scandal started to gather storm, we saw the pound take another pounding – only to rise this week to levels prior to the news release! It is hard to say whether even further quantitative easing would lead to pound weakness. Remember when the ECB announced quantitative easing measures? Traders took it as a positive sign and bought up the euro!

It is difficult to say what is in store for the British economic and political landscape. Will we see the UK government take action to help keep their precious credit rating? Will we see lawmakers move to kick Prime Minster Brown to the curb? Will the British economy continue to show some punch?

It isn’t tea time just yet. A lot of work has to be done before one can sit down, bust out his tea cups and say, “Two teaspoons of ‘Brown’ sugar please!”