Forget About Euro ETFs, British Pound ETFs Are The Real Danger

by on March 19, 2010 | ETFs Mentioned:

In recent weeks, the future of the euro has been a hot topic among investors, as the current “stress testing” of the common currency system has uncovered some worrisome flaws. The euro has slumped against many of its major rivals as fears about escalating budget crises in Greece, Spain, and Italy have caused investor anxiety. But for all the focus on the euro’s struggles, most investors do not realize so far in 2010 British pound ETFs have lost more ground than euro ETFs. The CurrencyShares British Pound Trust (FXB) is down 6.7% year-to-date, compared to a loss of 5.6% for the CurrencyShares Euro Trust (FXE). This sharp downturn in the pound comes as Britain finds itself in the worst fiscal situation since World War II. Some estimates put the current UK budget deficit at roughly 12.7%, on par with Greece. On the heels of Greece’s budget woes, this news comes much to the dismay of continental Europe, which is growing increasingly concerned over the fiscal condition in the British Isles. Recently the EU called on Britain to introduce immediate measures to prevent the shortfall from worsening in the next financial year.

Bank of EnglandAdding further fuel to the fire is British Liberal Democrat leader Nick Clegg, who said recently that Britain could face massive political and social unrest on a scale similar to Greece if the next government cannot rally the public behind plans to cut the £17billion deficit. According to Clegg, if the structural deficit in the public finances is to be eliminated without further tax increases, at some point in the next eight years government spending will have to fall by as much as 10%, which could lead to a severe backlash from the public.

Some have even called for a British pound devaluation as a remedy to this situation. While this would make it easier for the country to pay its debts, it is hard to believe such a move would help the country in terms of exports. Once an industrial powerhouse, the UK is now almost entirely service-based with hardly any exporters of note. The iShares MSCI United Kingdom Index Fund (EWU) for example, allocates 22% of assets to financials, 20% to energy, and 15% to consumer staples. However, it is important to recognize that the vast majority of the energy firms either do work in the North Sea or completely outside of Britain, so a devaluation would do very little in terms of boosting demand by making British goods cheaper.

The one element that Britain has going for it is the long duration of its outstanding bonds. Unlike many other developed markets that are deeply in debt, Britain was able to issue more longer term notes, which will help it prevent a funding crisis in the near future. Britain’s weighted average maturity of government bonds is 14.2 years, significantly higher than France (7.1 years), Italy (6.9 years), Germany (6.4 years), or Japan (5.7 years). This could give the country greater flexibility in the near future.

Despite the long duration, some are growing increasingly worried that the situation in Britain is shaping up to be a repeat of “Black Wednesday,” when legendary financier George Soros famously shorted the pound and made more than $1 billion in a single day of trading. This came after the pound quickly devalued after an end to trading against the German currency in a band in the early 1990′s.  While unlikely, a similar situation could be brewing in present day Britain should the country not be able to fund its debts or if it sees a large increase in its cost of borrowing. Either situation could heavily impact FXB and send it sharply lower.

So while continental Europe’s problems may be subsiding, the worst could still be ahead for Britain. Investors considering buying British pounds should remain extra cautious while the country sorts out its budget difficulties, and consider safer currencies in the region such as the Swedish krone (FXS) instead.


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Disclosure: no positions at time of writing.