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GBP/USD Outlook
A Return to Carry Trade Investing Boosts the Pound, but Will Yield Differentials Continue to Drive the GBP/USD?
The British Pound’s astounding rise leaves many traders wondering whether the currency will continue to rally through the second quarter of 2007.

After reaching 15-year highs against the Dollar, some analysts wonder if the unit is now susceptible to a retracement. Interest rates remain the key to further pound gains. With US short term rates having reached their peak, the GBP/USD could appreciate on a progressively growing yield differential. Continued spread widening leaves the strong GBP/USD uptrend in play, but such an outlook clearly depends on the future of short-term interest rates.

The chart below emphasizes the strength of the relationship between yields and currency movements through the past twelve months of trade. The US yield advantage peaked in July, 2006, allowing the GBPUSD to set a firm bottom and reverse its previous downtrend. The currency pair subsequently scaled 15-year highs when UK short term rates surpassed their US counterparts through the first quarter. Implied rates predict that the Pound’s yield advantage will continue to grow through the medium term. All other things remaining equal, this leaves risks to the topside across GBP pairs.

 Where are Short Term Interest Rates Going? Will the Bank of England Raise Rates Once More?
Futures contracts show expectations of a 70 percent chance that the Bank of England will raise rates by 25 basis points by May. Given that the Monetary Policy Committee left policy unchanged at its April meeting, many feel that it is only a matter of time before officials opt to tighten further. There may be significant obstacles to such a move, however, with key events through mid-April to weigh heavily on market sentiment.

From a trader’s perspective, the outlook on the Pound may take a significant turn when the Bank of England releases its most recent monetary policy minutes on April 18th. The MPC communiqué took markets by surprise when officials revealed that they voted 8-1 to keep borrowing costs unchanged. Most analysts expected seven MPC members to vote for stable rates and two in favor of a hike. Instead, the one dissenting vote was in favor of a cut.

Pound bulls hope that history will fail to repeat itself, producing a much more hawkish result in the next official vote. Anything less than two MPC members in favor of a hike would likely trigger selling in the pound as traders speculate that the UK Central Bank is less likely to raise rates in the near future. Market sentiment notwithstanding, there will be a number of other factors weighing on the bank’s final decision.

Will Inflation Moderate According to Plan, or is Further Policy Control Necessary?
In its February Inflation Report the Bank of England said it expected inflation to remain elevated through the near term. They cited a 3.0 percent print through December as a real risk to price stability, but declining energy costs would bring headline inflation back to target. CPI growth has since dropped to 2.8 percent through February, but it is decidedly unclear that forecasts of lower inflation will come to pass. Indeed, a renewed uptrend in oil prices threatens to derail expectations of moderating energy prices through the medium term.

Housing shows signs of slowing, risks to consumption?
Strong domestic consumption has clearly been one of the driving forces of broader UK growth and underlying inflationary trends. This can be seen through double-digit house price growth over the past year, with the HBOS Housing Index printing at 11.1 percent through its most recent read. One can certainly argue that stronger home prices allow the consumer to extract home equity for increased consumption. Looking at the BoE mortgage data, UK home owners withdrew £14.6 billion in home value through the final quarter of 2006—the highest since Q1, 2004. The risks to overheating consumption are undeniable. In fact, equity withdrawal peaks in late 2003 preceded a pronounced slowdown in house price inflation and a moderation in consumption growth. Evidence for a similar top through Q4, 2006 is mounting: according to the central bank, Mortgage Approvals have fallen significantly off of November’s multi-year highs. Though such a drop could prove temporary, risks seem weighed to the downside on reports of overall declines in house-purchasing activity.

Housing Not the Only Downside Risk; Industry Shows Material Signs of Slowdown
A recent slowdown in domestic Industrial production places considerable risks on expectations for higher rates through the medium term. Manufacturing Production fell 0.6 percent through the month of February—its worst result since October, 2005. This left year-over-year Industrial growth at a paltry 0.3 percent and instantaneously cut expectations of a March rate change from 45 percent to 25 percent on an intraday basis. Given potential gains in input costs and moderating consumer spending, the outlook seems bleak for a significant portion of the economy. Of course, it is important to note that the Services sector may look to offset such declines. A jump in Services PMI underlines bullishness among purchasing managers, leaving risks to the topside for future growth.

The Euro-Sterling Exchange Rate Looks to Gain on Material Risks to BoE Outlook, ECB Tightening Cycle
As for EUR/GBP, the medium term uptrend in the currency pair has been the direct result of a narrowing spread differential between short term Euro Zone and UK interest rates. With markets virtually certain that the European Central Bank will raise rates further through the medium term, it seems that the confusion surrounding forecasts for the Bank of England will leave the pair bid through upcoming trade. Coupled with bullish technical momentum, it will take an unexpectedly dovish ECB or hawkish BoE to erase the sharp EUR/GBP rally seen through the first quarter.

Conclusion
The countervailing forces of rising inflation and moderating economic growth leave risks for both steady or higher rates.. April will prove an especially critical month for short term yields, with key MPC Policy Meeting Minutes due on the 18th and Gross Domestic Product figures available on the 25th. Market expectations will hinge on the former, while the Bank of England’s stance on monetary policy will clearly depend on economic expansion data. Reactions in implied yields will likewise have a tremendous impact on the GBPUSD. One only needs to look at historical yield spreads to know that they are one of the most important factors in currency valuation. As such, our outlook for the Pound is admittedly mixed, but it seems increasingly plausible that the central bank could choose to leave rates unchanged through the medium term—which could cause  the British Pound to retrace its most recent gains.

Technical GBP/USD Outlook
On a monthly closing basis, the GBP/USD has held above the breakout point of 1.9549 for 5 months (a close above that level in April would be the 6th). A broader look however reveals that the pair has traded sideways since the November 2006 breakout in what may be a distribution top.  Given the psychological significance of 2.0000, it is unlikely that the GBPUSD will break higher with ease.  In fact, reversals occurred at 1.9990 in February 1991 and at 2.0035 in September 1992.  The EURGBP chart also points to British Pound weakness (relative to the euro) as there are 5 waves up from .6535 to .6866, indicating that the larger trend is higher (a small correction lower appears to be taking place now).  From an Elliott view in GBPUSD, there are 5 waves up from 1.7047 to 1.9914, so at least a correction lower is expected.  Corrections often return price to the 4th wave of one lesser degree.  In this case, the 4th wave low is at 1.8515.  This is also close to the 50% retracement  of 1.7046-1.9514 (1.8481).    A weekly close above 1.9914 suspends a call weakness and shifts focus to the 1992 high at 2.0035.