Pound Gets Boost from Hawkish BoE, Yet Risk Trends Remain Driver of Price Action

GBP/USD

The GBP/USD surged in early trading as the hawkish tone to the BoE minutes raised the outlook for a rate hike. Bullish conviction would wane as equity markets started off on a sour note as risk sentiment remains the main driver of the pair’s price action. Stocks continue to hold a 43% correlation with the pair which has strengthened from 28% a week ago. Prior to today’s reaction to the central bank’s statements yield expectations have been on the decline which has become a weighing factor for the pair and lead to its influence on direction increasing to 35% from 22% the week prior.

GBP/USD’s Correlation with Risk Firms

BoE Interest Rate Expectations

The BoE minutes revealed that the MPC “stood ready to respond in either direction” but concerns over tight credit conditions and growth keep the majority from voting for a rate hike. Andrew Sentence for a third straight month was the lone proponent for tightening as he sees inflation becoming unanchored. As a group policy makers see the potential for CPI to be higher with the expected rise in the VAT. Despite the hawkish tone to the minutes interest rate expectations have been on the decline for the U.K. with overnight index swaps falling to 14.7 bps from 38.2 at the end of July. Former BoE member David Blanchflower recently commented that the economy may need more quantitative easing before any removal of stimulus could be considered. Upcoming U.K. retail sales, mortgage approvals and public net borrowing reports will have a big impact on yield expectations going forward. A rising budget deficit, tight credit conditions and declining consumer spending could sink the sterling. Discuss this and trading ideas join the GBP/USD forum.

FOMC Interest Rate Expectations

A 1.5% rise in wholesale prices eased deflation concerns while a 1.0% gain in industrial production gave hope that manufacturing growth is sustaining. However, signs that the labor market is struggling to regain its footing has sunk interest rate expectations for the Fed which has been a dragging force for the dollar. Indeed, fed fund futures are currently reflecting the dim outlook for yields with markets giving a zero percent chance that a rate hike will come before the end of the year. Jobless claims and manufacturing data will provide further insights into the pace of growth and the labor market but will have minimal impact on longer-term yield expectations.

Risk

Speculation over an increase in M&A activity boosted confidence on the street helping stocks erase an early dip. Longer-term growth concerns continue to be overshadowed by strong corporate profits and the prospect that the Fed will keep interest rates on hold through the first half of 2011. The Dow has found support after testing the 38.2% Fibo of the June-July rally, but we could be seeing a bearish channel developing which may see an ultimate test of 10,000. For now the short-term perspective appears to be driving direction and a test of 10,600 may come before extended weakness. Discuss this and other fundamental data in the Economics Forum.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com