Pound Is Poised for Goldman Rally Not Helping Brown

By Ye Xie and Anchalee Worrachate

Oct. 26 (Bloomberg) -- The U.K. pound, trading at the cheapest level against the euro in a decade, is making everything from Ipods to Toyotas less expensive for foreigners and turning Goldman Sachs Group Inc. into a sterling bull.

Purchasing power parity, a measure of the relative cost of goods, shows the currency is 22 percent below where it should be, according to data compiled by Bloomberg. Sterling hasn’t been so inexpensive since 1999 after Bank of England Governor Mervyn King flooded the economy this year with 175 billion pounds ($285 billion) buying government bonds to keep borrowing costs from rising as the economy shrinks.

“The U.K. is cheap, its properties are cheap, its companies are cheap,” said Stephen Jen, a money manager at BlueGold Capital Management LLP in London and the former head of foreign exchange at Morgan Stanley. “Friends and family who have visited me always complained about the cost of living in London, but they have since stopped complaining.”

U.K. assets from houses to soccer clubs have been discounted as the seizure in credit markets drove the economy into its worst recession since World War II, forcing Prime Minister Gordon Brown’s government to take stakes in two of the nation’s biggest banks. Brown, whose Labour Party trails behind the Conservative opposition by 17 percentage points according to an Ipsos-Mori Ltd. poll last week, must call an election by June.

Gross domestic product unexpectedly shrank 0.4 percent in the third quarter, the Office for National Statistics said on Oct. 23, continuing the longest contraction since records began in 1955.

Mergers, Acquisitions

Sterling declined 0.3 percent against the dollar to $1.6266 today, and fell 0.4 percent versus the euro to 92.38 pence on speculation the faltering economy would prompt the central bank to expand its asset-buying program. The pound had gained 1.2 percent versus the dollar and 0.7 percent compared with the euro in the four days before the GDP report.

The pound’s slide is fueling mergers and acquisitions in the U.K., bringing the first net inflows to the country in three years, Bloomberg data show. The last time that happened, in 2006, the pound jumped 2.1 percent versus the euro and 13 percent against the dollar, the biggest gain in 16 years.

Goldman predicted this month that sterling will appreciate 9 percent versus the euro to 84 pence by year-end, and by 14 percent to $1.85, even as U.K. debt quintuples as a percentage of gross domestic product. Jen sees the currency climbing 7.6 percent to $1.75.

Taylor Rule

Investors underestimate the risk of the Bank of England increasing its key interest rate from the current all-time low of 0.5 percent, according to a study by Frankfurt-based Deutsche Bank AG based on the Taylor Rule, an economics equation for predicting central bank moves based on policy makers’ tolerance for inflation and unemployment.

The Taylor Rule shows the rate should be about 2.75 percentage points higher, Deutsche Bank said in the report. Futures contracts predict less than a quarter-percentage point increase by April 2010, the biggest disparity among the Group of 10 economies, according to the study.

“The Bank of England is the most out of line among the G- 10 nations in terms of policy,” said Henrik Gullberg, a strategist in London at Deutsche Bank, the world’s largest currency trader.

King’s Comment

The rate is likely to rise to 1.25 percent by the end of 2010, with increases starting in the second quarter, according to the median of 10 economists’ estimates compiled by Bloomberg. The European Central Bank and Federal Reserve probably won’t boost borrowing costs until the third quarter, separate surveys show. Rates will rise “at some point,” King wrote in an opinion piece in Scotland’s Herald newspaper on Oct. 21, adding “it would be wise to take this into account.”

Consumer prices are poised to rise faster in the U.K. than in any other developed economy. The inflation rate in Britain will be 2.1 percent this year, compared with 0.3 percent in the euro region and a decline of 0.4 percent in the U.S., according median estimates in surveys by Bloomberg News.

The pound fell 4.4 percent against the dollar in August and September, the steepest two-month drop this year, amid speculation King and his Bank of England colleagues favor a weaker currency and expanding the central bank’s asset-purchase program. It lost 6.9 percent versus the euro, prompting Citigroup Inc. and BNP Paribas SA to predict sterling would reach parity with the 16-nation European currency by the first quarter of 2010.

Borrowing Binge

Brown is committing unprecedented amounts of cash to spur growth and rescue banks such as London-based Lloyds Banking Group Plc, the nation’s largest mortgage provider, and Royal Bank of Scotland Group Plc in Edinburgh, the 282-year-old lender that was Europe’s biggest bank by assets.

His Labour Party had the support of 26 percent of voters compared with 43 percent for the Conservatives and 19 percent for the Liberal Democrats, the London-based Ipsos-Mori market research company said on Oct. 20. Mori polled 996 people between Oct. 16 and Oct. 18.

The government’s budget deficit will climb to 175 billion pounds in the year ending March 2010, or 12.4 percent of gross domestic product, the most in the Group of 20, according to an April forecast from the U.K. Treasury. The deficit was 77.3 billion pounds in the first six months of this year, the largest for any half-year period since records began in 1946.

‘Ridiculously Cheap’

“The story in the U.K. is not great,” said Peter Lucas, an investment strategist in Jersey, Channel Islands, at RBC Wealth Management, which has $430 billion in assets. “There might be scope for the pound to rise in the near term, but these underlying issues do require the pound to be an undervalued currency for some time.”

Hedge funds and other large speculators held record wagers this month that the pound will decline against the dollar, with so-called net shorts increasing eight-fold from the end of August to 65,346 on Oct. 13, before declining to 43,318 last week, data from the Washington-based Commodity Futures Trading Commission show. The figures reflect holdings in currency- futures contracts at the Chicago Mercantile Exchange.

“Sentiment for sterling is extremely negative,” said Nigel James Rayment, a money manager in London at JPMorgan Asset Management, which oversees $1.3 trillion, including $60 billion in foreign-exchange assets. “Against the euro, it looks ridiculously cheap,” with fair value at about 80 pence, he said.

The pound may rally to $1.80 by year-end, according to Rayment, who co-manages the JPMorgan Sterling Managed Currency Plus Fund, which beat 89 percent of its peers this year with returns of 13 percent, according to Bloomberg data.

Foreign Buyers

Kraft Foods Inc., the Northfield, Illinois-based maker of Oreo cookies, bid 10.2 billion pounds for Cadbury Plc on Sept. 7. A Saudi Arabian investment firm backed by Prince Faisal bin Fahad bin Abdullah al-Saud, the chairman of sports investor F6, is considering buying a stake in Liverpool, the English Premier League soccer team, F6 director Barry Didato said Sept. 29.

Overseas companies announced or completed $34.7 billion of U.K. company takeovers this year, bringing a net $4.1 billion into the country, according to Bloomberg data. That compares with outflows of $2.3 billion in 2008 and $152 billion in 2007.

“Fresh money is coming into the U.K.,” said Thanos Papasavvas, who helps oversee $4 billion as head of currency management at Investec Asset Management Ltd. in London and increased bets this month that the pound will appreciate. “There’s enough doom and gloom on the pound, but investors are wrong-footed.”

Overseas investors bought 4.27 billion pounds more U.K. gilts than they sold in August, the most since February, Bank of England data show.

Stock Bargains

For Europe-based money managers, the average cost of buying U.K. stocks dropped 13 percent from a year earlier as the pound depreciated, according to Bloomberg data.

U.K. stocks outperformed their peers in Europe and the U.S. in the third quarter. The FTSE 100 Index rose 21 percent, its best performance since at least 1984, compared with a 17.8 percent gain in Europe’s Dow Jones Stoxx 600 Index and a 15 percent advance in the Dow Jones Industrial Average.

Consumers can snap up bargains too. A Toyota Motor Corp. three-door Yaris hatchback costs 9,905 pounds in the U.K., compared with 12,090 euros, which is the equivalent of 10,909 pounds, in France, according to the Web site of the Toyota City, Japan-based carmaker. A 160-gigabyte Apple Inc. Ipod Classic is priced at 183.90 pounds at Amazon.com in the U.K., versus 214.95 euros, or 193.97 pounds, in Germany.

‘Too Bearish’

Goldman Sachs advised clients to buy the pound in March, and dropped the recommendation when the currency climbed to $1.65 in June, a bet that returned 12 percent when accounting for changes in interest rates. It began backing the pound again on Oct. 15.

“The market is way too bearish on the U.K. economy and way too short sterling,” said Thomas Stolper, an economist at Goldman in London. “The Bank of England has a history of surprising the market.” King may boost rates as soon as April, said Stolper.

Barclays predicts the pound will rise about 8 percent to $1.76 in March, and gain 7.6 percent to 85 pence per euro.

“There’s more inflation pressure in the economy than people realize,” Paul Robinson, a currency strategist at Barclays Capital in London who worked as an economist at the Bank of England for 11 years until 2006. “The BOE is likely to tighten policy a bit earlier than the market thinks. Sterling has to appreciate as the clouds clear.”

To contact the reporters on this story: Ye Xie in New York at yxie6@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net