A Pound Of Flesh: A Medium-Term Outlook For GBP/USD

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 |  Includes: FXB, UDN, UUP
by: Cerebro1

Forex movements affect our everyday lives and decisions. One such situation is all too real for a colleague of mine whose daughter is studying medicine in the U.K. Month after month she gives me a call asking for my advice on whether to purchase U.S. dollars or the British pound Sterling to settle her daughter's educational obligations. Her objective is to act upon any opportunities which present itself in the FX market in order to alleviate the burden of financing her daughter's British pound denominated education. Indeed, tertiary level expenses want their pound of flesh from one's salary and monitoring market movements can be a way of easing these demands on income. Luckily for my friend the pound has devalued 6.17% versus the U.S. dollar. The currency pair moved from its high of 1.639 in the beginning of 2013 to the current levels of 1.545. This move may be attributed to worse than expected economic data, divisive comments from the Cameron administration and a lack of maneuvering from the Bank of England (BOE). As I have informed my colleague, this decline appears to be temporary. In the medium-term GBPUSD looks to be range bound. Thus, acquiring the Queen's currency at these levels may provide a 6% move to the upside. Investors who wish to speculate on a long position in the British pound should consider the ETF CurrencyShares British pound sterling Trust (NYSEARCA:FXB).

Preliminary figures of U.K. GDP were disappointing at best, with investors scrutinizing whether the U.K. economy may enter a triple dip recession. Initial estimates have U.K. Q4 GDP at -0.3% versus the BoE expectations of -0.2%. These poor results were part of the declines over the past couple of months. However, the majority of the declines in GDP may be attributed to unusual maintenance work in the North Sea. Approximately 90% of the economy grew at a 1% pace over the past year while the remaining 10% of the economy, particularly the volatile construction and oil & gas sectors, declined by more than 10%. The chart below illustrates U.K.'s GDP quarterly growth.

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These sharp falls in these sectors are unlikely to be repeated in 2013. Therefore, further downside on the pound versus the U.S. dollar appears to be limited. The chart below shows the GDP projection for the U.K. based on market interest rate expectations and the BoE's asset purchase program.

Expectations for economic growth in the U.K. is anemic at best but a continued easing in domestic credit conditions along with the BoE's asset purchase programme, and the Funding for Lending Scheme (FLS), compounded with a stronger global economy, together underpin a slow recovery in both demand and effective supply.

What also added to the weakness of the pound is the Cameron Administration's intention to re-negotiate its relationship with the EU. In fact, if the government were to be re-elected in May 2015, a referendum on the U.K. exiting the EU will be held by the end of 2017. A U.K. exit from the EU could deter investment in the U.K. if access to the European Single Market Economy and the U.K.'s contribution to shaping the EU will be tremendously reduced. Furthermore, figures from the EU show that the current U.K.'s access to free trade within the EU could add 0.1- 0.22 percentage points per annum to U.K. trend growth. The statement came as a shock to markets and aided the decline in the pound, however, given that the referendum will be in the May 2015 elections, any further downside moves are not expected and investors will look to 2015 to see what the real results will be. As such, a neutral view on the pound is warranted.

With the U.K.'s CPI inflation up 2.7% in December, from 2.2% in September the BoE may be unable to further stimulate the economy without risking further inflation pressures. The rise in inflation was as a result of increases in university fees and retail energy bills. Oil prices were slightly higher in December than in September.

At the latest meeting, the U.K.'s Monetary Policy Committee maintained its Bank rate at 0.5% and its asset purchase programme at 375 Bn pounds. With inflation around the target of 2%, the BoE appears constrained in its powers to stimulate the economy. As such, it would be difficult for GBPUSD to return to levels seen in 2007 and further depreciation below 1.50 is unlikely as the there is both QE and the FLS available. Thus, we can consider GBPUSD to be range-bound in the medium term.

On a Weekly Chart one can see the range bound movement in the pound versus the U.S. dollar. From as early as September 2011, GBPUSD has been trading between 1.5233 and 1.638, a 7.5% distance between the two points. Accordingly, investors with a medium-term scope can purchase FXB when GBPUSD is trading around the 1.52 price level and short FXB when GBPUSD is trading near the 1.638 price level. The potential benefit is 7.5%. The chart below shows the weekly price closes of GBPUSD.

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To avoid paying the pound of flesh in tuition fees, my colleague can now monitor to purchase her pounds at these current levels and benefit from the upside potential in the near future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.