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Saturday, October 24, 2009

UK in dire strait

Posting from Paris...

The market continues to punish British pound, now the euro/pound exchange rate declined to 1.08, not far from parity. UK's economy has declined for the consecutive 6 quarters. (reports WSJ)

A note from Goldman Sachs said it all. The U.K.'s latest gross-domestic-product data showing the economy shrunk by 0.4% in the third quarter and by 5.2% over the past year was "Unbelievable. Literally."

This result wasn't just at odds with the Bank of England's 0.2% growth forecast but was out of line with recent survey data showing economic pickup.

If the official statistics are right, then the U.K. is in more trouble than the market thought. A sixth consecutive quarter of economic contraction would confirm this as the worst U.K. recession since World War II.


But the Office for National Statistics has a poor track record of explaining what is going on in the economy. Goldman Sachs notes the correlation between the ONS's first estimates of quarterly growth and the actual outcome is just 0.10. That suggests this data is very likely to be revised upward.

Even so, the data could provide just the excuse the Bank of England's Monetary Policy Committee needs to expand its quantitative-easing program. That should boost the government-bond, or gilt, market which had recently started to sell off, assuming recent positive economic signals would complicate the BOE's ability to continue buying gilts.

Good news for gilts, however, looks like bad news for sterling. The combination of the poor GDP data and any expansion of quantitative easing will reduce pressure on the U.K. government to address its dire fiscal position. With the Treasury already on course to overshoot its £175 billion ($291 billion) borrowing forecast this year, the biggest risk to the U.K. remains that the markets conclude its triple-A rating also is literally unbelievable.