The pound is looking sickly again. As financial markets took fright at the gathering crisis in Greece and other Euro-zone countries, sterling suffered a sharp sell-off. From mid-April to late May, it shed more than 8 per cent against the US dollar, which is a sizeable move in the foreign exchange markets. And despite a partial recovery since, its prospects continue to look poor.

Britain's public finances are in a mess. The previous government's overspending during the good times left the country with unbalanced books even before the credit crunch bit. The budget deficit last year ran to £156bn - around 11 per cent of the total size of the economy. As a result, the national debt is expected to swell to £1520 billion in 2011.

Of course, Britain is not alone in having unbalanced books and a large national debt. But the country's position has worsened faster and more seriously than that of many others. Both the general public and the new government now realise that severe belt-tightening is required to shrink the annual deficit and the overall debt.

Prudence's ugly side

Even before this week's budget was published, the government's agenda was clear: to slash public spending and to raise taxes. To ease the pain of this, the Bank of England has said it is committed to holding down interest rates at very low levels for some time. Such a combination of fiscal tightness and monetary looseness are the worst possible conditions for the pound.

It's easy enough to understand why low interest rates reduce a currency's appeal. Just as a higher interest rate attracts money from abroad, a lowered one has the opposite effect. But why fiscal tightness should be bad for a currency may be less obvious. After all, should not foreign-exchange investors be happy that a country is putting its finances in order?

As the accompanying chart shows, this is not the case. The blue line shows the annual change in UK public spending and the red line shows the annual change in the average of the Euro/Sterling rate. (I've used the ECU before the Euro's creation in 1999.) You can see that generally the two lines move together. Increases in public spending lead to a stronger pound, whereas cuts lead to sterling weakening. This could be because higher spending is interpreted as a sign of a strong economy, and thus benefits the pound.

Economic jitters return

The government's cut-fest comes just as the global economic recovery has started to show signs of faltering. Leading indicators of activity for the US have begun to roll over negatively, pointing to slower growth and perhaps even worse. Much of continental Europe is in a ropy state, which does not bode well for British exporters, given that Europe is our biggest trading partner.

This has already fed through into financial markets, particularly equities and commodities. If this continues, it would also be bad news for sterling. British assets like shares and bonds are relatively heavily owned by foreigners. In an environment of reduced risk appetite, they lighten up their holdings, selling UK assets and switching the proceeds from sterling to other currencies.

Economic theory says that £1 should be worth around US$1.52. And it's not actually that far off that level now. Over time, the pound has been a lot cheaper than it is today in relation to the US dollar. In the 1980s and early 1990s, there were occasions where sterling was 15 per cent below economic fair value.

Of course, the US has many of the same problems that the UK does, especially excessive levels of public and private debt. But in times of nervousness, investors are still inclined to retreat for the safety of America's currency. After all, the dollar is the most liquid currency in the world, and during a credit crunch, that counts for a great deal. All this suggests the pound is likely to continue its recent depreciation in US dollar terms.

PART II

It isn't just macroeconomics that points to sterling losing further ground against the dollar. The message from the charts is that the pound is set for a further pummelling. Sterling is in an unmistakeable downtrend in relation to the US currency. While it rallied hard between from early 2009 until the summer of that year, it has since slid backwards. And the pace has accelerated in recent months.

Having sold off to as low as $1.423 in late May, the pound has rebounded quite some way. But the nature of that comeback is not cause for celebration. Whereas the decline that preceded it was deep and decisive, the recovery has been shallow and hesitant. This is a classic clue that the ascent is merely a correction against the direction of the larger downtrend.

In order to go any higher, sterling would have to surmount some stiff obstacles. One of these is the daily Ichimoku cloud - the pink shaded zone on the chart. This is basically just a Japanese version of a moving average, which has been projected forwards in time in order to show future resistance. This level repelled two previous sterling rallies in January and April. At the moment, the top of the daily cloud lies at $1.488.

Even if sterling were to get above its daily cloud, it faces an equally powerful barrier in the shape of its 21-week exponential moving average. This indicator is currently positioned at $1.507. Sterling has pointedly shied back from this level on numerous occasions during its current bear market and during prior downtrends.

My technical projections suggest that sterling has a good way to fall once its downtrend resumes in earnest. In the currency markets, trends tend to consist of three main phases, being two moves in the main direction with a counter-trend move in between them. The big drop from November 2007 to January 2009 was the first phase, while the rally into last August was the second. The pound is therefore in its third and final stage of its descent.

This third phase could well travel a good deal further than it already has. Typically, the different phases of a trend are in some sort of proportion to one another. At the very least, this suggests that sterling will drop to $1.322. In a more severe sell-off - which I believe is entirely possible - it could end up at $1.22 or even $1.09.

Of course, this devaluation will take some time to play out. However, the likelihood of a reversal towards the recent lows at $1.423 in the short term is fairly high. And it could be close to a significant turning-point in time as well as in price. A 45-day time cycle in the sterling/dollar rate has recently peaked, hinting at weakness heading to around 7 July. And a particularly ripe date for a turn would appear to fall on 24 June.

Those also interested in the longer-term outlook for sterling should also be aware that monthly cycles continue to point downwards heading into the head of the year, with a possible bottom occurring in November.

Under the circumstances, I would recommend attempting a selling sterling and buying dollars over the coming month at the current level of $1.49, targeting a move back to the lows at $1.423, covering the short position on a move to $1.52.

The Covered Warrants tip has been written by Dominic Picarda this week, on behalf of Simon Thompson.

© Dominic Picarda Covered Warrant tips