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Most of the clues required for the British pound's direction for 2013 are contained in the Bank of England's last Inflation Report back on November 14, 2012. The British pound enjoyed a relatively strong 2012, and outgoing BoE Governor Mervyn King is not happy about it:

"Well I never call for changes in exchange rates; they are things which are given by the market to central banks. But I think it's fair to say that the increase in the effective exchange rate of sterling - after all in the last year, just over, 15 months, since the middle of 2011 when the euro area crisis intensified, the effective exchange rate of sterling has risen by 8% and against the euro by 12%. That is not a welcome development."

The theme of driving the British pound lower came up again as King implied that such action may be the UK's only option to achieve the economic rebalancing required to return to a health economy (emphasis mine):

"…GDP growth is more likely to be below than above its historical average rate over the entire forecast period. The subdued recovery reflects a judgment that the global environment will remain unfavorable. We face the rather unappealing combination of a subdued recovery with inflation remaining above target for a while. An unfavorable external environment continues to shape our prospects. The international imbalances which played such a pivotal role in the run-up to the crisis still remain. The pattern of surplus countries reluctant to expand domestic demand to protect their trade position and deficit countries restraining domestic spending to reduce their debt ratios is only too familiar. It is a recipe for weak global growth.

For a country like the United Kingdom attempting to rebalance her economy such an outlook poses real challenges. If that unfavourable world environment persists - and there is little sign of any change to the underlying problems in the euro area - it may be unreasonable to expect anything other than a slow and protracted recovery absent a further fall in the real exchange rate."

As this passage shows, King's economic outlook is somber, perhaps outright pessimistic. This notable change in tone was picked up by several reporters during the question and answer period. One reporter referred specifically to page 40 in the Inflation Report that explained the downgrade in the GDP forecast (emphasis mine):

"Further out, the weaker GDP profile reflects the judgment that the broader causes and repercussions of the financial crisis may bear down more forcefully on demand and productivity than assumed in previous Reports. There seems a greater risk that the UK economy may be in a period of persistently low growth. Compared with previous Reports, the Committee has assigned less weight to the possibility that growth will be materially above its historic average…"

The BoE essentially lowered the upper part of its range, driving the average downward. The BoE is not bracing for potentially even worse scenarios (not yet anyway).

During the Q&A, King explained this increased pessimism as follows:

"I think this goes back to what I said at the beginning, which is not just the UK, but the world economy is having to move to a new real equilibrium - to use the economists' jargon - in which those countries that were borrowing a lot from abroad have had to - will have to reduce the scale of that borrowing and reduce those deficits, and countries with large trade surpluses will have, one way or another, to adjust the balance of their economy to rely less on exports surpluses. It's proving extremely difficult to bring about that adjustment to the real equilibrium, and in that process the world economy is growing more slowly, and so any deficit country like ours, which is trying to make that adjustment, is confronted with a major difficulty in rebalancing at a time when global demand is very weak…

The entire world is going to have to change its pattern of growth, and this is proving very difficult to bring about, particularly in a world where key countries are trying very hard to resist movements in relative prices that would facilitate those adjustments. And that is a major problem that we face. And I don't resile from that. I think we have become more concerned about this problem ever since the euro area crisis became more serious in the second half of last year. And that's why I think over the past 12 months we've become more concerned about the ability of the UK simply to ignore what is going on in the rest of the world economy. We can't - we are faced with quite serious constraints on what we can do."

King elsewhere reiterates his pessimism regarding the economy in continental Europe and notes the direct impact on the UK: "We face a difficult challenge in our biggest export market - the euro area plus the countries around it account for one half of our trade. The prospects there look pretty bleak. This is a very difficult environment in which the UK economy is trying to rebalance."

Countries in debt need to stop borrowing to buy exports. Moreover, countries in debt must reduce debt by exporting more to countries sitting on large surpluses ("what the UK economy needs is more demand in the rest of the world to buy goods from the United Kingdom"). This process cannot occur as long as the surplus countries import relatively little, in this case due to weak demand. There remains little upside for surplus countries to build greater surpluses by increasing exports to countries deep in debt:

"The entire world is going to have to change its pattern of growth, and this is proving very difficult to bring about, particularly in a world where key countries are trying very hard to resist movements in relative prices that would facilitate those adjustments."

This theme of rebalancing is not new, especially for King. What seems different now is that King has clearly given up the last vestiges of hope that rebalancing will occur anytime soon. In doing so, he sees little wiggle room for the UK to expand its economy. Protracted economic weakness combined with the central bank's claim that the currency is too high suggests to me that the British pound (NYSEARCA:FXB) is not likely to advance much further in 2013. Against the U.S. dollar, the pound is near the top of an approximate range in place since 2009.

(click to enlarge)

An approximate trading range has largely held in GBP/USD since 2009

Source: FreeStockCharts.com

Perhaps King can achieve some solace in noting that the upper bound of the current range against the U.S. dollar is in a slight decline. Assuming it holds, 2013 promises to lower the trading range ever so gradually.

While King would likely love to drive the British pound back down using monetary policy, presumably through more asset purchases, he acknowledges the limits to this strategy. He even seems to say that the UK is fast approaching the limit:

"…as you go through the process of adjustment to a new real equilibrium, there will be difficulties in trying to persuade people to hold off getting there. You can't postpone forever the adjustment to the new real equilibrium. And that's why, if monetary policy is trying to slow down that adjustment, it can do so for a while, it can do so up to a certain amount, but it can't do so forever. And it's in that sense that all monetary policy instruments, including asset purchases, have limits. And that's where we are now, which is we are needing to make the adjustment to rebalance the economy and there is no way that asset purchases can put that off indefinitely. And we are trying to do it at a very difficult time when the world economy is weak."

This recognition suggests to me that the British pound likely has downside limited by the bottom of the approximate range shown above. In other words, 2013 promises more of the same for the British pound.

It is certainly possible that the Bank of England uncovers some new creative way to drive the currency down. After all, King looks back proudly at the ability of his team to engineer a take-down of the pound without stoking (WAGE) inflation:

"This is the first time since the Second World War when the United Kingdom has been able to absorb a very large depreciation of its currency without domestically generated inflation wage costs picking up. I think that's an achievement for monetary policy and I think the MPC can be rightly proud of that."

Regardless, given King seems to believe that monetary policy could be reaching its limits for the UK, it is easy to understand his alarm when he looks into 2013 and projects that countries will up the ante on competitive devaluation to achieve monetary policy and economic goals. On December 10th, Bloomberg quoted King as saying in a speech in New York:

"the G-20 has gone backward since (2009), and there has been no agreement on the need for working together to achieve some element of rebalancing the world economy. My concern is that in 2013 we'll see the growth of actively managed exchange rates as an alternative to the use of domestic monetary policy."

As this dynamic plays out in 2013, the British pound may even get tagged a "safety currency" as traders and investors seek shelter from the forces of competitive devaluation. Those bouts of strength will offer occasions to go short as eventually the overall weakness of the UK economy should make the trade less and less attractive. Assuming the trading range holds firm, sell-offs in the British pound will offer opportunities to go long the currency as the BoE is unlikely to manage any new tricks to force the currency through apparent support levels. While a continued trading range may frustrate trend traders, it does provide a modicum of risk management with stops conveniently set just beyond the boundaries of the range.

Given the extended duration of this trading range, any breakouts or breakdowns will force me to consider the possibilities for a continuation of the momentum. This trading range could be serving as a coiled spring from which at some point in the (distant) future, a sustained trend will finally develop. For now, I am more inclined to short the pound as it trips its way to the top of the range. I will take on trades with the pound versus other currencies on a case-by-case basis.

Be careful out there!

Source: 2013 Forex Outlook: More Of The Same For The British Pound

Additional disclosure: In forex, I am likely to short the pound in the coming days or weeks.