Betting Against the British

By shorting Sterling, you’re hitching your investment wagon to a now well-established trend. Since touching an eye-popping $2.11 in November 2007, British Pound Sterling already has dropped more than 19%. That pace has noticeably accelerated in the past few weeks. As recently as mid-July, the British Pound Sterling was still fetching $2 to the pound. During the last six weeks, the British Pound Sterling has lost more than 10%. And here’s why I think the British currency is set to fall at least another 10% before the end of the year.

First, the negative news coming from the United Kingdom during the past few weeks has been relentless. The United Kingdom’s economy is in much worse trouble than the economy in the United States. The U.K. housing bubble was bigger than that of the United States, and U.K. housing prices have fallen by 11% in a year. At the end of 2006, U.K. household mortgage debt was 126% of GDP, against a mere 104% in the United States. Consumer-price inflation is widely expected to hit 5% this year — more than twice its official target. Unemployment is edging up. The U.K. economy has come to a screeching halt in the three months prior to June for the first time since the early 1990s. Last week, the Paris-based Organisation for Economic Cooperation and Development (OECD) forecasted that Britain will be the only G7 economy to experience recession this year.

Second, the British Pound Sterling still is one of the most overvalued currencies in the world. Even after its recent fall, $1.76 buys far more in the United States than £1 does in the United Kingdom. Morgan Stanley estimates that in purchasing parity terms, the British Pound Sterling should be at around $1.60 to the dollar, just about the average dollar exchange rate since 1985.

Third, once the bottom drops out of a currency, it tends to overshoot, both on the upside and the downside. On September 17, 1992, George Soros “broke the Bank of England,” and made $1 billion in the process, by betting that the United Kingdom would devalue the U.K. currency, the British Pound Sterling. Yes, the pound has lost more than 10% against the dollar in the last month. But I believe it has another 10% to go before it pauses, and then perhaps overshoots even that level. After all, in 2002, the British Pound Sterling traded as low as $1.40 at one point.

So sell the CurrencyShares British Pound Sterling Trust (FXB) at market, and set your stop (buyback price) at $188. Note that currencies are generally much less volatile than any stock. That means that you can probably take 2x or even 3x your normal position size. I am going to hold off on recommending options on FXB right now as the pound sterling’s recent sharp drops means that options are valued quite highly. But look out for an option recommendation in the coming weeks.

PORTFOLIO UPDATE

Currency bets are the place to be in these tough markets. Your bet on the collapse of the euro through the Market Vectors Double Short Euro ETN (DRR) now is up almost 10%. Tighten your stop to $42.50. Your position in Direxion Funds Dollar Bull 2.5x Fund (DXDBX) is up 5.3% in just three weeks. Tighten your stop to $33.75.

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