Disconnect Between Credit and Raising Red Flags for the British Pound

By Evaldo Albuquerque

The British pound, like many other currencies, has been appreciating against the battered dollar lately. However, UK and U.S. share a lot of the same problems, especially regarding the levels of public debt.

Granted, UK’s economy has shown some signs of improvement, especially in the housing market. Besides that, the labor market has stabilized and manufacturing activity has picked up.

So there’s a good chance that inflation expectation will increase in the next few months. As a consequence, the British pound is getting some support from the expectations that the Bank of England will raise rates to control inflation. But the medium-term outlook for the currency is not that bright.

The currency market is categorically underestimating UK’s fiscal problems. Due to the country’s rising debt burden,  the rating agency Standard & Poor’s has already lowered the outlook on the U.K.’s AAA rating to “negative” from “stable”. A downgrade will certainly be the next step if U.K. government doesn’t take any measure to address its fiscal mess.

In fact, the chart below shows that the cost of insuring U.K. government debt against losses (measured by Credit Default Swaps) has been increasing lately. It now costs more to insure top-rated British debt than it does Slovenian bonds, graded AA by Standard & Poor’s.

So prices in the credit market definitely reflect a higher risk of a credit downgrade. The British pound, on the other hand, has been holding its ground above the 1.65 levels. Something’s gotta give!
5 year Credit Default Swap reflects increasing risks of default, but currency doesn’t


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