Pound Support Could Falter with Stocks at Critical Support Levels

GBP/USD

The GBP/USD built upon yesterday’s gains as domestic fundamentals and a return of risk appetite provided support. A decline in U.S. initial jobless claims helped ease concerns that the world’s largest economy is headed for a double dip recession providing a temporary boost to stocks. Risk sentiment has been the main driver of the pair’s direction holding a 45% correlation. Indeed, as stocks have erased earlier gains the pound/dollar has followed them lower. Meanwhile, the Confederation of British Industry retail sales report showed demand reached a three year high which was also a supporting factor as it helped raise yield expectations. The outlook for interest rates were in a decline and has contributed to recent sterling weakness as it holds a 32% correlation with price action.

BoE Interest Rate Expectations

Recent U.K. fundamental data has left markets just as confused as it was before on the course of U.K. interest rates. A rise in retail sales will put pressure on already elevated consumer prices adding to the case for tightening to begin. However, an 18.5% drop in home loans is evidence that credit conditions remain tight which may make it prohibitive for the central bank to raise rates. The MPC’s newest member Martin Weale is already cautioning of a double dip recession, if lending continues to dry up. Overnight index swaps are now pricing in 15 bps in hikes over the next year which is slightly up from 12.6 on 8/24, as markets still see little chance of a change in policy from the monetary authority. The upcoming second reading of 2Q GDP could alter the outlook for yields but is unlikely with expectations for growth readings to remain unchanged. Next week’s PMI manufacturing report will have the biggest impact of interest rate forecasts as the sector has been the main driver of growth. Discuss this and trading ideas join the GBP/USD forum.

The decline in U.S. initial jobless claims will do little to alter current yield expectations as the Fed is waiting for signs of job growth before tightening. Early forecasts for next week’s Non-farm payroll report are for a job loss of 106,000 in August. Therefore, we may see markets continue to expect the central bank to remain on hold for the remainder of the year and the first part of 2011. Fed funds futures are reflecting the dovish outlook as they see a zero percent change of tightening beginning by the end of the year.

Risk

We have been targeting the 61.8% Fibo of 9614-10,719 at 10,0036for the past week for the Dow and the blue chip index is now threatening to break below the support level. Prevailing pessimism over the building case that the U.S. and possibly the global economy is heading for a double dip recession has fueled a flight to safety putting pressure on stocks. However, 10,000 could prove to be a formidable barrier, but a break below exposes 9,600 and drag the GBP/USD lower. 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