Since the sizable move in the British pound early in the second quarter, the GBPUSD has been relegated to range trading. In fact, from the middle of August through the opening days of October, the pair has been unable to move beyond 1.9125 or below 1.8600.
GBP/USD Outlook
Since the sizable move in the British pound early in the second quarter, the GBPUSD has been relegated to range trading. In fact, from the middle of August through the opening days of October, the pair has been unable to move beyond 1.9125 or below 1.8600. This inability to break from its otherwise tight exchange constraints comes despite a surprise hike in the nation’s benchmark lending rate and a number of indicators supporting the possibility of another, similar shift in the months ahead. Chief among the factors playing into further tightening of rates is consumer inflation at recent record highs and retail price inflation, generally used as a benchmark for income negotiations, running at its fastest pace in nearly two years. However, the solid wall of optimism behind another rate hike is starting to crumble with realistic projections from outside the confines of the Bank of England’s generally accepted and buoyant predictions. Speculation behind the terminal point in the overnight cash rate will likely take on as much importance for the most liquid sterling pairings in the final three months of this year as any actual decision itself. This is particularly true given the current state of, and expected shifts in, rate levels in the other major economies of the world. There is already evidence that such speculation has taken hold. Against the US dollar, the British pound resiliently holds above the 1.86 level. Valuations against the Euro show the same sort of ‘stickiness’ around 0.67 even as lending rates in the European community climb at a consistent pace.
Getting Familiar With The New Bank Of England
Once again, the Bank of England’s Monetary Policy Committee (MPC) is at full strength. Stepping in for Richard Lambert at the beginning of September, Timothy J. Besley has already participated in two rate decisions. Besley, a professor of economics and political science from the London School of Economics, has revealed little about his bias towards policy. So far, his short track record puts him on par with his predecessor, Richard Lambert, who often followed Governor Mervyn King in his decisions. On the other hand Dr. Andrew Sentence in contrast to the departed David Walton who he replaced has already shown a dovish proclivity through an article he submitted to the UK Times back in June in which he supported the cause for a rate cut in the near future as the British economy begins to weaken. Meanwhile the BOJ Governor Mervyn King has maintained his hawkish posture by expressing his skepticism regarding the latest batch of inflation data, noting that the declines in September were “temporary”. Governor King’s comment suggest that he will seriously consider another rate hike before the year end which would UK short term rates to 5.0% though whether he has enough support amongst the rest of the MPC remains to be seen.
Caught Off Guard In August, Is A November Hike In The Cards?
In an unexpected move, the Bank of England decided to lift the overnight lending rate by 25 basis points to 4.75 percent at its August meeting. This outcome was almost entirely unexpected given the reduced staff of seven policy members and still questionable trends in recent economic data. Consequently, this impromptu decision produced a sizable run in volatility for the British pound not seen since the solid bid found in April. In retrospect, many economists have said the data lined up for policy officials before the rate decision was made suggesting such a shift was on the books, while a 40 percent chance of a rate hike going into the meeting was also the greatest since 2003. Looking ahead towards the November meeting, the probabilities of another rate hike implied with futures positions have grown markedly; and the same economic conditions contributing to August’s decision are still present. The biggest red flag leading many to believe another rate hike is in the works are the persistent inflation levels seen through the consumer sector. While statistics have shown prices paid by producers for raw materials have fallen significantly in recent months, the pass through has yet to be seen for the average Briton. In fact, the most commonly tracked inflationary gauge, the Consumer Price Index, accelerated to 2.5 percent for the August report. This matched the fastest pace of price growth in the consumer basket in nine years; and, not coincidently, was the same rate which the Bank of England had deliberated upon when convening in August. Another target to watch will be the Retail Price Index (RPI), which is often used in wage negotiations as a benchmark for cost of living. Currently standing at 3.4 percent, a 20-month high, the index suggests greater income will bolster consumer spending and further build the case for forecasts of above target inflation for months to come. In their most recent projections, the central bank has forecasted annual, headline inflation will run above the central bank’s 2 percent target rate for more than two years. Governor King has even gone so far as to suggest there is a “50-50 chance” that rates will breach the 3.0 percent mark with tuition, food and energy price increases by the first quarter.
Housing And The Consumer
Beyond the outlook for inflationary trends, there is also a foundation of support for strong economic growth in the coming months. In the most recent data from the Office for National Statistics, second quarter growth in the $2.4 trillion economy measured 0.7 percent. This rate matched the previous two quarters‘ pace and was quickest gait in a year-and-a-half. Looking ahead, sustaining this level of expansion will likely fall on the shoulders of British consumers and their spending habits. Recently, spending from this significant sector of the economy has shown promise. Consumption over the second quarter expanded 0.9 percent, while the Confederation of British Industry’s report for September grew to its highest level in 21 months. Furthermore, recent figures have also shown a rebound in confidence and strength in the housing market. September’s report of the Nationwide Housing Price Index accelerated to its fastest pace since January, while the RICS figure for the previous month grew to a May 2004 high. Despite all of these strong indicators, many of these trends are still in a fledgling stage and prone to an economic shock. For the housing market, higher prices will continue to drawl out the frugal side of many consumers. This will be especially true if the proposition of another increase to lending rates becomes a greater concern for the broad public rather than just the investment community. Since the most common form of financing for houses in the United Kingdom is through variable rate mortgages, another rate hike would quickly diminish the purchasing power of a vast portion of the populace. Consumer confidence and spending are also in a fragile state. While both the Nationwide Building Society and GfK measures of consumer sentiment have ticked higher in their most recent postings, the overriding trend has been towards weakness. The headline figure for the GfK proprietary read sank in its August reading to the lowest level for the year, while the expectations component dropped to its lowest point in two years. Decidedly worse, the Nationwide headline figure moved to its lowest since May 2004 over the same month. From its components, it was shown that respondents to the survey were more pessimistic over future home prices for the second month in a row while those expecting their incomes to fall in the coming three to six months reached an all-time high. These different indicators reveal the precarious position the UK economy is in given domestic sources of growth. Looking to foreign streams of income doesn’t necessary lend itself to a more persuasive outlook for growth either.
Currency Fluctuations to Impact Growth
Another potential obstacle for the Bank of England’s high expectations surrounding growth comes in the form of dubious forecasts for international trade. In recent months, the visible trade balance has improved somewhat since marking its largest deficit on record at 7.863 billion pounds in February. However, this improvement has been modest at best and the prospects for improvement in the immediate future are not promising. In this situation, the strong performance of the British pound has in the past, and will in the future, prove detrimental to levels of trade. Against the US dollar, the British currency has appreciated nearly 10 percent since the beginning of the year. In itself, this would choke off demand from the US, but expectations of a cooling economy in the months ahead may exacerbate the issue. Gross domestic product in the world’s largest economy was cut to 2.6 percent in the second quarter from a two-and-a-half year high 5.6 percent pace in the three months to June. Economic performance is expected to follow the same path in the following months as the Federal Reserve has put rates on hold and pointed a cautious finger at the sharp contraction in the housing market. While easing in the US is likely to stunt export growth markedly, the concern over struggling global demand will likely be epitomized through European links, specifically Germany. Expansion in the regional economy reached a five-year high 2.6 percent annual pace in the second quarter, but forecasts are bleak. The source of such expectations lays in the hike in Germany’s value added taxes from 16 to 19 percent, due to take effect in January. Projections of how this will affect the German economy have already been taken into account with the ZEW investor confidence indicator plunging to a seven year low. Even European Central Bank President Jean-Claude Trichet has forewarned consumption will be hit by this impending policy change.
Conclusion
In the months ahead, the direction of the British pound will be determined by the United Kingdom’s ability to keep pace in the rate rivalry, the health of domestic demand and the maintenance of international trade. Rates in particular will take on a new level of importance in the final quarter of the year after the hike in August has pushed speculation of yet another one to near certain levels in futures markets. On the other hand, even if the domestic overnight cash rate finds another boost, it may not be enough to keep pace (or catch up to) the other industrialized nations’ monetary policy plans. Furthermore, the burden of higher lending rates and perhaps a more expensive currency could wear on economic growth through stifling domestic and foreign demand. Looking ahead, it is obvious that the Bank of England walks a fine line; and participants in the currency market are well aware of this fact.
Technical Outlook
Cable rallied in early August to its left shoulder high at 1.9140 (February 2004). Like EURUSD, the GBPUSD head and shoulders pattern is ultimately bearish and 1.9140 provides a point of reference from which to establish a bias. Bearish divergence with oscillators on daily and weekly charts reinforce the bearish head and shoulders pattern. Cable recently broke below a 6 month supporting trendline – drawn through 1.7249, 1.8176, and 1.8602. The definitive break bolsters the bearish argument and sets the stage for an attack on the 7/25 low at 1.8383. Bearish targets going forward are the confluence of the 6/29 low / 50% of 1.7046-1.9144 at 1.8090/96 and the 61.8% at 1.7850. The 61.8% Fibonacci level intersects with October 2005 and January 2006 highs. Longer term, a move lower would complete the 3 wave (A-B-C) correction of the 1.3682-1.9548 uptrend. Wave C (beginning at 1.9144) would equal wave A at 1.9548-1.7046) at 1.6642. The 50% retracement of 1.3682-1.9548 is at 1.6615. Weekly oscillators are declining and RSI is just above 50. RSI has not been below 50 since April 2006 (when GBPUSD was at 1.7511). A push above the 8/8 high at 1.9144 negates the bearish interpretation. Focus would then shift to the 4/20/2005 high at 1.9215 and the 3/8/2005 high at 1.9323.
GBPUSD Weekly Chart (Source: FXTrek Intellicharts)
GBP/USD Positioning
Speculative British Pound longs reached a new record for the week that ended on 8/18. GBPUSD had topped out the previous week at 1.9144. The chart below shows a strong correlation between speculative positioning and GBPUSD prices. Speculative positioning declining from extreme levels favors GBPUSD weakness going forward.