Meanwhile, the British pound spent the first half of 2006 falling against the Euro in volatile trade as the European Central Bank was far more aggressive in monetary policy action. However, once the Bank of England started to ring a more hawkish tone in the second half of the year, EUR/GBP racked up losses as the pair fell to 17-month lows. With inflation appearing to be a greater risk in the UK than in the Euro-zone or the US, the British pound may be the beneficiary of monetary policy tightening by the Bank of England in 2007, especially if either the European Central Bank or the Federal Reserve opts to keep a neutral stance. Furthermore, regardless of what the Bank of England decides to do, a single rate cut by the Federal Reserve would put rates in the UK and US at parity, creating ample opportunity for the British pound to surge through 2.000 against the greenback and to take aim at the 2004 lows just above .6500.

M&A Activity Continues to Fuel the Pound
 
Throughout 2006, the British pound has received a significant boost from an increase in merger and acquisition transactions in the U.K. The value of takeovers of UK companies by foreign buyers this year has shot up by 11 percent to 172 billion pounds - the highest since the peak of the dotcom boom in 2000. Increased protectionism measures in the US have made the UK’s business friendly market increasingly attractive to international investors, as the UK's share of the M&A market was the second highest in the world at 9.4 percent, beaten only by the US. Of the 157 hostile takeover bids which took place this year – 87 percent higher than last year - nearly a third were in the UK, such as Nasdaq's unresolved takeover bid for the London Stock Exchange. Other M&A activity included Iberdrola’s pending 13.5 billion pound takeover of ScottishPower and Edinburgh Airport operator BAA's 15.2 billion pound buyout by Spanish group Ferrovial. The current merger wave has underpinned benchmark equities, which have surged more than 12 percent since the beginning of 2006. Ultimately, the renewed interest in UK based entities looks to spur further appreciation in the underlying currency as merger demand could continue, bolstering the need for FX conversion. This has already been seen in both the GBP/USD and EUR/GBP currency pairs. Nearly $59 billion of cross border flows from the US to the UK have pushed Cable to 14 year highs in December, while $99 billion in flows from the Euro-zone to the UK have helped the EUR/GBP cross drop to 15-month lows in October and November. However, should the current level of M&A activity mark a peak globally, both UK benchmark equities and the British pound could be in for declines in 2007.

Housing Sector vs. the Bank of England

Back in August 2005, the Bank of England cut rates 25 basis points as the UK housing sector had grinded to a halt, leading to tepid consumer spending and dismal GDP growth of 1.7 percent. House prices, as measured by Rightmove, bottomed out at an annual rate of 0.2 percent in August 2005, but as lower interest rates resonated through the markets, housing inflation picked up quickly. In fact, as of December 2006, Rightmove house prices sit at a 25 month high of 13.0 percent, despite two rate hikes by the BOE (in August and November) to a five year high of 5.00 percent. The surge in demand for properties in the UK led to a shortage of supply, which has helped accelerate prices even faster. While this pick up in the sector has contributed to greater consumer confidence and spending, it has also led to rampant borrowing, which is translating into broader inflation pressures in the UK economy. Indeed, M4 money supply has held at 16-year highs throughout 2006 and was a major reason cited by the BOE for monetary policy tightening during both rounds. Although M4 slowed to 13.1 percent year over year in November, the figure is still well above average and puts the BOE in a precarious position. While central bankers will be cautious and desire to preserve economic expansion, they will also need to be prudent in attempts to cool the housing market as well as broad money supply, which ups the ante for a Q1 rate hike to 5.25 percent. Monetary policy tightening along with falling affordability for potential home buyers should lead demand for properties to decline, and thus a slowdown in house price growth in 2007.

Changing of the Guard – Who Will Step in for Blair?

With discontent for British Prime Minister Tony Blair mounting throughout 2006 over issues such as the war in Iraq and the “cash-for-peerages” scandal, the government chief announced that he would depart sometime in “the next twelve months.” However, with May 2007 marking the tenth anniversary of his premiership, many are predicting this will be the approximate date of his departure. With the position up for grabs, many politicians have shouted the battle cry and announced they will vie to become the next Prime Minister of the UK. Chancellor of the Exchequer Gordon Brown is widely expected to take over the office with ease, however, left-winger John McDonnell declared he would stand against Mr. Brown, if only in the interests of democracy to prevent an outright coronation. Additionally, Conservative leader David Cameron called for a general election after Mr. Blair steps down, while Liberal Democrat leader Menzies Campbell said his party was preparing for one as early as 2007. Nevertheless, the markets will likely prepare for the introduction of new policies by Mr. Brown, who plans on cutting thousands of civil service jobs between 2008 and 2011, while introducing new taxes to fight VAT fraud as well as increasing spending on education. Generally, national currencies do not take kindly to such policies. Thus, should Mr. Brown take office as Prime Minister in 2007, not only will the political turmoil cause volatility for the British pound, but the event could lead it to depreciate as well.

Central Bank Action to Drive EUR/GBP

While UK merger and acquisition activity, broad based economic growth, and rising house price pressures have been major contributors to the British pound’s strength against both the dollar and the euro, central bank activity may turn into the primary driver of price action in 2007. As the Federal Reserve likely has fully completed their 2 year long tightening cycle and have held a steady hand since June 2006, indications that the US central bank will be moving towards a dovish round leading to more accommodative policy could cause a wave of US dollar liquidation, especially if the market still believes that the Bank of England will look to hike rates by mid-2007. A single rate cut by the US Fed or a rate hike by the Bank of England would put benchmarks for the two countries at parity for the first time since January 2006. Additionally, the European Central Bank has wrapped up 2006 with extremely hawkish comments that signals at least one interest rate hike in 2007, possibly as soon as the first quarter. Such an aggressive stance should benefit the Euro significantly at the detriment of the British pound as the interest rate differential between the two currencies shrink even further.

Conclusion

Going into 2007, there is an array of event risk laid out for the British pound, as many of the drivers of strength for the currency were likely a temporary occurrence. First, housing prices can only remain elevated for so long, as dwindling affordability will eventually lead 2006’s insatiable demand to ease back. Additionally, there are concerns that the surge in mergers and acquisition activity noted in the past year may signal a major downturn globally, which could potentially hurt both UK equity markets as well as the British pound. Furthermore, a shift in leadership in the UK government could potentially go smoothly should Gordon Brown take office as Prime Minister without significant conflict. However, it is far more likely that other political parties will fight to purge the ranks of members of the Labour Party, which will only spark volatility in the FX markets. In the end, though, the Bank of England may hold the resilience of the British pound in their hand, as a tightening of monetary policy along with a rate cut by the US Federal Reserve could vault Cable over the 2.0000 level.

Technical Outlook

The GBPUSD is in the same position as the EURUSD.  The rally to 1.9847 may have been the 5th wave of the 5 wave bullish sequence that began one year ago on December 2nd at 1.7046.  The recent high at 1.9847 is accompanied with bearish divergence (RSI) on the weekly chart.  Previous instances of bearish divergence near overbought levels (on the weekly) have led to sizeable declines.  The evidence favors a decline in the coming months to correct the mentioned 5 wave rally.  Fibo support begins at the 38.2% of 1.7046-1.9847 at 1.8779.  Unlike the EURUSD, there is not a nice intersection of fibo support and the long term trendline.  In fact, the long term trendline does not come into play for quite a while (the recent rally in Cable has been steep).  What is interesting to note is that the rally from 1.8090 (the bottom of the 4th wave and beginning of the 5th) took the shape of a diagonal triangle (overlapping waves).  Diagonal triangles often end with a thrust through the top of its resistance line, after which the entire rally is eventually retraced.  The 61.8% fibo of 1.7046-1.9847 is at 1.8118, very close to the bottom of wave 4 and the beginning of the diagonal triangle.  That fibo level intersects the long term trendline in May.  Technical evidence points to a topping out at 1.9857 but a rally through 1.9857 exposes the psychological 2.00 figure and the 1998 high at 2.0100.     

 

GBPUSD Weekly Chart (Source: FXTrek Intellicharts)

GBP_USD