During the heyday of the Thatcher administration some quarter century ago the administration sold off the family silverware when they took companies such as British Gas, British Steel, Rolls Royce and the TSB out of the public sector and sold shares to the public in a string of de-nationalizations. The rise of the shareholder class boosted confidence across Britain and saw increased participation in the stock market once private investors began to understand the meaning of corporate performance. The slogan widely used to launch the sale of British Gas to the public was Tell Sid, which encouraged the public to spread the good word about buying into the plan. This week, poor Sid would be turning in his grave to learn that the government was forced to buy one of the nation's flagship banks in an effort to prevent systemic collapse of the banking sector. Latest rumors are swirling that the next bank is on the chopping block. Apart from an injured 'Dunkirk spirit' the other casualty is the British pound, which has now lost around one-fifth of its value against the dollar.
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The pound is currently trading at around $1.3750 against the greenback – some way off the $2.11 during the summer. Back in 1992 during the crisis surrounding Britain's expulsion from the exchange rate mechanism, the pound also went into freefall and the policy response on the other side of the move is today echoed in the words spoken by Mervyn King, governor at the Bank of England.
Essentially, while the woes are real there is a very positive side to a devaluation of a nation's currency. It does stimulate export demand. The governor does seem to be embracing the devaluation, which is understandable since such measures are often adopted by governments to ensure their economies are competitive. After all there is precious little one can do about a run on your pound. Put another way, you won't find Robin Leigh Pemberton, then governor at the Bank of England sharing a cuppa tea with George Soros. The Hungarian billionaire and philanthropist is known for making a billion pounds out of the short sale of the pound, betting on its loss of value against the German mark. Those proceeds were sent back to help educate orphans in his native Hungary.
A competitive devaluation is one of the policy measures that the government can adopt to help stabilize the economy. After all, with interest rates at 1.5% there is little room for further downside, but we're still sure that this will be eroded. Fiscal stimulus has already been dispatched by the government, but not so that you'd know given the December jump in the number of workers losing their jobs. That reading was the second highest since 1991 as the tight policy mix at the time was starting to topple the economy. Mervyn King dropped a heavy hint this week that the Bank is close to ready and willing to start buying commercial paper and fast decaying assets in the banking system. This measure, according to Mr. King, is designed to save the people from the banks rather than to save the banks from themselves.
But the chaos this banking breakdown has brought to the pound seems to contrast sharply to the impact it's had on the dollar, which is the epicenter of the banking crisis. The difference? The pound doesn't wear the same crown as the dollar, which is that of world's reserve currency. The severe pressure that the pound has come under, during which time it's registered an all-time low against the Japanese yen, is a far-cry from the dollar's experience. While many investors (wrongly) anticipated dollar weakness, we have to point out that the dollar is once again closing in on a cycle high against the euro, which should come into focus next week at a guess.
In last week's essay, we tracked the large amount of put buying by investors betting the yen would decline. We attempted to justify the tremendous jump in put open interest by questioning the self-fulfilling status of carry-trade unwinds and whether there really were any investors left in the trade. This week, continued equity market weakness has once again boosted the desire to hold the yen and this is possibly behind a sudden closure of a substantial build in bearish put interest at the March 105 strike where overnight some 15,000 put positions have been closed. The yen is currently trading at the PHLX at 111.08.
However, the story throughout the last week has been one of marked dollar strength. This has little to do with a wave of optimism greeting President Obama but more to do with the apparent other shoe-dropping in the financial sector. It would actually seem more accurate if we said next instead of other. Share prices across the sector dropped around 11% on Tuesday as measured by the Financial Select Sector SPDR (Ticker: XLF). Across our data table, we find that the dollar has risen since last Wednesday across each of the six major currencies.
Checking the changes in open interest at the PHLX, also find that investors' modus operandi since that time was to close call positions and lengthen put positions across the board. The exception here was in the Canadian dollar where open interest readings at both puts and calls declined. This theme was notable each day as we looked at daily activity logs where we could see investors buying euro puts expiring in both March and June at the 120 strike. The open interest is similar at both but between them now account for one third of total open interest of 152,000 lots. This leaves the number of bear positions against the euro at three times the bull call position in open interest numbers.
Open interest in Aussie puts doubled to around 35,000 over the week with investors targeting the March 62.0 strike puts. The Aussie currently trades at 65.14 with support for this cycle coming in at 60.0. The projected growth decline in Europe doesn't help the appeal of growth-conscious currencies such as the Aussie, which could be on its way to a fresh low should weaker commodity prices prevail.
The build in pessimism surrounding the euro is a real contrast to predictions at the start of the year when analysts predicted dollar weakness. So what's behind the build in put options on the euro, which currently predict a fresh new low for this move before the middle of the year? Well that's all to do with an abandonment of growth in the Eurozone with investor reeling at the prospects of this week's prediction by the ECB of an economic contraction of 1.9% for 2009.
Dealing with a banking crisis in the U.S. might be like herding cats, but at least investors can visibly see the efforts being made to deal with the crisis. Investors might feel more confident in the authorities' powers and efforts to resolve the crisis than they do in those of the Europeans who have a lid to snap on to their own bucket of eels.