The pound has nowhere to go but down

It's official.

"We are going into recession," said the Chancellor, Alistair Darling, yesterday (actually, I think you'll find we're already in one, but let's not be picky). "I remain confident we will get through it."

Well, of course we will. This isn't the Black Death we're talking about here. It's a recession. The real question is how long will it last, and how nasty will it get?

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And judging by the performance of the pound yesterday, the answer is very long and very nasty indeed

Sterling is diving against the euro and the dollar

Yesterday we learned that unemployment has hit an 11-year high of 1.82 million. Meanwhile, the governor of the Bank of England, Mervyn King, warned that he couldn't rule out deflation, and warned that interest rates would fall "to whatever level necessary."

So it's little wonder the pound tanked.

Sterling hit a new record low against the euro yesterday. A pound will now buy you less than €1.20. At this rate, it won't be long before the average exchange bureau will be offering one-for-one after commission charges. Holidaymakers won't get much relief by choosing to travel to the US instead the pound's also diving against the dollar. It's now $1.50 (for more on the pound's longer-term prospects, see our recent currency crisis cover story if you're not already a subscriber, subscribe to MoneyWeek magazine).

The tumbling pound is one reason why Mr King also issued a gentle warning about using 'fiscal stimulus' to prop up the economy. He thinks this is a "perfectly reasonable" idea, as long as it's "temporary" and it's clear that there's "a medium-term plan to bring tax and spending back into a sustainable balance."

No doubt we'll be hearing more about that at the pre-Budget report, now officially scheduled for Monday 24 November. With the pound so weak, Mr Darling will have to perform a real balancing act. On the one hand, if it doesn't look like the government can ease the impact of recession, the pound will weaken. On the other, if it looks like the government is cheerfully going to blow another big chunk of our money without a care for how to pay it back, the pound will fall too.

The US does a U-turn on the Tarp bail-out

So I suspect any spending or tax cutting plans will be less spectacular than we're being softened up to believe. I'd imagine that the government's aim will be to scare the money markets with rumours of over-spending, then have the pound bounce when the reality is revealed to be far tamer. That won't save the pound in the longer run as the economic news gets even worse, of course but it might prevent any 'sterling crisis' headlines after the Chancellor's big speech.

But that's just my guess. After all, politicians around the world seem to be having trouble deciding on what they're doing from one day to the next. Look at US Treasury Secretary Hank Paulson. He's just hammered the US stock markets by performing a U-turn on his $700bn Tarp bail-out. He's now decided the rest of the money (about $410bn) shouldn't be spent on buying up dodgy mortgage assets, but on other ways to tackle the crisis. Not surprisingly, this scared Wall Street because it means that Tarp isn't working.

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"If it's not going to do what it says on the tin, then it's not going to provide a systemic solution to the financial crisis," Divyang Shah of Commonwealth Bank of Australia told The Telegraph. The money's now going to be spent on a broader range of things more stakes in banks, stakes in non-financial companies, attempts to revive the "consumer asset-backed securities market" and in trying to cut down on repossessions.

That doesn't sound like a strategy to me that sounds like a fire-fighting fund. As FT Alphaville puts it, "mortgage assets aren't even going to be bought anymore. It looks like auto-loan securities and credit card receivables will be though: sop to Detroit, or taxpayer investment at the peak of a collapsing market? You decide."

Why you should avoid stocks at the moment

Richard Beales on BreakingViews argues that the change of heart does at least make some sense. "One big problem with the Treasury's original scheme was the difficulty determining the price at which to buy the illiquid mortgage-related assets that everyone else was having trouble valuing. It always made more sense to avoid this whole problem by recapitalising financial institutions directly."

But regardless of whether this is a better use of the money or not, investors are starting to learn (once again) what happens when you get the government involved in the markets. As soon as you get the politicians sticking their oar in, traditional valuation measures go out of the window.

You can't know what anything should be worth anymore, because the rules could change from day to day. A stock that should be worth nothing might get bailed out. A company that's very profitable might end up whacked with a windfall tax to pay for it.

It's yet another reason why I'd be inclined to avoid stocks for now. Rising unemployment and diving earnings are bad enough without having to contend with government tinkering as well.

By the way, don't miss The Money Programme on BBC 2 tonight at 7.30. MoneyWeek teamed up with the programme's producers to look at whether it makes more sense to rent or buy a property over the long term. We think you'll find it quite an eye-opener.

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