British Pound Soars on King’s Comments, 1.50 is Resistance

Over the past 2 weeks, the British pound has soared more than 8 percent against the U.S. dollar. Like many countries around the world, the U.K. has succumbed to higher gas prices but unlike some other countries, the weakness of the British pound has exacerbated the rise in inflation. Hotter consumer prices helped to fuel today’s gains in the British pound, but it was comments from Bank of England Governor King that took the GBP/USD above 1.47. Quantitative Easing has been kept a lid on gains in the pound, causing it to under perform currencies such as the euro. The CPI numbers are significant however because annualized CPI is now BACK ABOVE the BoE’s 3 percent target.

However this morning, BoE Governor King talked UP the pound, which is a dramatic departure from his previous comments. He said that there is “no reason why the sterling should go any lower” and that the sterling’s fall was not engineered. He also said that the central bank originally aimed for GBP75bn of Asset Purchase Facility over 3 months but “might need to do less if it works.” These positive comments are probably a reaction to the recovery in the equity markets and the recent drop in bond yields.

The 1.4650 level in the GBP/USD is fairly significant (100-day SMA). If the currency pair manages to hold above that level, the next area of resistance is 1.50.

source: eSignal

source: eSignal

British Pound: How Much Further Can It Fall?

The British pound has fallen to a 7 year low against the US dollar and a record low against the Japanese Yen. Over the past 3 trading days, the GBP/USD has dropped more than 1000 pips or 7 percent. Consumer prices were hotter than the market expected, so what has fueled this aggressively selling?

One answer – FEAR

The market is afraid that the UK will turn into the next Spain or Greece. Over the past few months, they have been working overtime to inject more stimulus into the economy, but the more that they spend, the worse impact it has on the UK’s fiscal position. Deteriorating public finances has been the primary motivation for the recent downgrades of sovereign debt ratings by Standard and Poor’s. The FSA has dismissed this rumor but that doesn’t mean that the UK can’t be put on credit watch negative which would be one step before a downgrade. Investors are selling now and asking questions later because a downgrade would mean more losses for the British pound. Whenever a country loses its AAA rating, funds that are mandated to invest in only AAA assets need to liquidate and shift their positions elsewhere. We have seen this with Spain and could see it again with the UK.

Bank of England Governor Mervyn King will be speaking later today and he will probably attempt to calm the markets. But with employment data and the minutes from the latest monetary policy meeting due for release, his impact may be limited.

How Low Can the GBP/USD Fall?

The British pound has broken 2 key support levels – 1.45 and 1.40. Trends can last for a very long time in the currency market which is why there is a decent chance that we could see the GBP/USD slip to 1.3685, the June 2001 low. If that price level is broken, it would be a 16 year low for the currency pair. The 1.40 level is pretty critical on a closing basis. If the GBP/USD closes above 1.40 today, we may actually see a larger bounce, but don’t expect the currency pair to revisit the 1.45 level any time soon.

Monthly Chart of GBP/USD:

source: eSignal

source: eSignal

Bank of England Expected to Cut Interest Rates to 1.5%

The Bank of England is expected to cut interest rates by 50bp on Thursday to 1.50 percent, an all time record low, yet the British pound is rallying.

This bizarre price action stems from the fact that pound traders are looking beyond the rate cut and onto the BoE’s aggressive efforts to revive the struggling economy.

Furthermore a recent uptick in economic data suggests that a 50bp rate cut may not be the only option for the central bank.

mervyn king

mervyn king

The BoE could also entertain the notion of a smaller quarter point rate cut following the improvements in retail sales, manufacturing and service sector PMI. Inflation also remains above the central bank’s target even though they believe that price pressures will fall sharply in the coming months.

Since 2008, the BoE has already cut interest rates by 350bp. As long as the central bank does not surprise the market with a 75bp rate cut, regardless of how much they ease, the British pound will remain the fifth lowest yielding currency in the developed world. Although interest rates have never fallen below 2 percent in the history of the BoE, they will be forced to make this historic move as there is no convincing evidence that a rebound is near. The undeniable willingness of the BoE to respond diligently to market troubles leads us to assume that a rate cut is all but certain.

Expect a lot of volatility following the BoE rate decision especially since the monetary policy statement could provide clues to how much further the central bank may lower interest rates. Given that Chancellor Darling warned that the recession was from over, we could see UK interest rates hit 1.00 percent.

Bank of England Won’t Stand in the Way of the British Pound

The British pound is on a tear even though the minutes from the most recent monetary policy meeting indicates that the BoE toyed with the idea of cutting interest rates by more than 150bp.

The markets are ecstatic about the Bank of England’s proactiveness even if it means that UK interest rates will probably drop below 2 percent. Given the tone of the BoE minutes, we expect another 100bp rate cut at the next central bank meeting. The BoE is on a roll right now and the market expects big moves. Anything short of another 100bp rate cut could be a big disappointment. At the moment, the BoE is the most aggressive G7 central bank and expect the pound to join the ranks of the low yielders. However once the excitement dies down, we expect the pound to resume its weakness against the US dollar and Euro as the country closes its interest rate differential with the US dollar and the Euro.

King Can you believe that the Bank of England considered cutting interest rates by more than 150bp at their last meeting. According to the minutes, they only limited the rate cut to 150bp and not 200 or 250bp because they were afraid of shocking the markets. As I recall, 150bp at that time was quite a surprise at the time! The decision was unanimous with all 9 members of the monetary policy committee backing the 150bp rate cut that took interest rates down to 3 percent.

Here are the specific reasons that the BoE gave for not easing more (in order of appearance in the minutes)

1. Uncertainty regarding fiscal policy
2. Desire to assess how measures to stabilize the financial system are working
3. Unwillingness to shock markets
4. Desire to retain some ammunition to support confidence in coming points

Point #1 suggests that we could see further fiscal stimulus by the Chancellor later this month. The UK government has gone above and beyond all of their G7 peers in trying to stimulate their economy, which should help speed up the recovery in the UK economy.

The MPC minutes also indicated that the BoE will not stand in the way of the British pound. The central bank wants to gradually ease interest rates (if 150bp can be seen as gradual) to limit the sell-off in the pound, so that it does not cause a sharp run up in inflation. Clearly, the BoE has no qualms about the 25 percent depreciation in value of the British pound against the US dollar and they are quite comfortable with further weakness in the currency as long as it is gradual.
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What Happens if UK CPI is Greater than 3%?

The British pound was hands down the best performing currency today as it rose against the US dollar, Euro and Japanese Yen. This was partially due to dollar weakness and the expectation that tomorrow’s consumer price figures will be hot.

king Like the rest of the world, the UK has not been immune to the sharp rise in crude, but one unique problem that Bank of England Governor King faces that his peers do not is the need to publicly explain himself. Consumer prices are currently at 3 percent and if it rises any higher than that, King will be forced to submit a letter to Chancellor Alistair Darling explaining why inflation has increased more than 1 percent above their 2 percent target and how he plans to bring inflation down. He is also required to give a timeline on when he plans on achieving this and that may include an interest rate hike.

This is the only the second time ever that the central bank governor has written this letter of explanation to the Chancellor since the BoE was granted independence in 1997. Interestingly enough, the last letter was also written by Mervyn King to then Chancellor Governor Brown (click here for the 2007 letter).

Therefore expect this to be a big week for the British pound.

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