A Surging U.S. Dollar And Carney Overwhelm Bullish Underpinnings For The British Pound

Jul. 8.13 | About: CurrencyShares British (FXB)

Last week was a great week of economic news for the United Kingdom. The apparent economic improvement seems to be unfolding just as Mervyn King seemed to suggest in his final appearance as Governor at the Bank of England's (BOE) Inflation Report almost two months ago. However, this news was drowned out by the much larger upward momentum that has carried the U.S. dollar index to a major breakout. This muffling is quite similar to the way the market ignored the positive news coming out of May's Inflation Report for almost three weeks before the British pound (NYSEARCA:FXB) finally rallied (and swiftly!).

This time around, an additional downward catalyst came from within. New BoE governor Mark Carney threw buckets of ice water on the encouraging economic reports by aiming a healthy dose of jawboning at rising interest rates.

First, the bevy of economic news from last week.

On Monday, July 1st, the June Markit/CIPS Manufacturing Purchasing Managers' Index (PMI) for the U.K., similar to the U.S. Institute for Supply Management (ISM) for Manufacturing, clocked in at 52.5, comfortably above expectations for 51.4. The PMI recorded a 2-year high and its strongest 3-month growth since early 2011.

On Tuesday, July 2nd, the June PMI for Construction printed 51.0 vs. a 51.2 expectation, a 1-year high. Confidence is at its highest level since April, 2012 as the industry appears to be stabilizing.

On Wednesday, July 3rd, the June PMI for Services blew expectations out the water, printing 56.9 versus the 54.9 expectation. This reading is a 2-year high as new orders grew at a rate not seen since 2007.

Wednesday's news garnered the strongest response with the pound surging off one-month lows versus the U.S. dollar (NYSEARCA:UUP). The economic news generated more headlines that Carney could not argue for more stimulus as the market had come to expect. (Such talk has been strange given Carney already has a record of hiking rates off rock-bottom levels in Canada and given former Governor Mervyn King was consistently outvoted in his attempt to increase asset purchases). The chart below shows that this response was very short-lived.

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The ever-volatile British pound

On July 17th, the minutes from last Thursday's decision from the BoE's Monetary Policy Committee (MPC) should reveal whether or not Carney specifically argued for more stimulus. However, the BoE came up with a trick that was just as effective in generating the desired market reaction. The magic words came in the following quote (emphasis mine):

"Since the May Inflation Report, market interest rates have risen sharply internationally and asset prices have been volatile. In the United Kingdom, there have been further signs that a recovery is in train, although it remains weak by historical standards and a degree of slack is expected to persist for some time…

…At its meeting today, the Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report. The significant upward movement in market interest rates would, however, weigh on that outlook; in the Committee's view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy."

As the chart shows, the reaction was immediate and strong. The British pound lost against all major currencies; against the U.S. dollar, it logged a new 1-month low. The aftermath of the U.S. labor report sent the pound to a fresh 4-month low. After that, the pound will be at levels last seen three years ago.

Given the steady improvement in the UK economy, I once again think the sell-off is way overdone. I hate to argue against the market - it is much bigger and better capitalized than I am! - but in this case, I am compelled to make a tentative exception. I have once again started accumulating a long position on GBP/USD. A retest of the 2010 lows around 1.43 will make me particularly aggressive. Interestingly, there is no currency which is particularly attractive to use as a hedge because all the major currencies are taking turns playing the weak partner in what is now a well-established game amongst central banks in tweaking policies and statements to goad their currencies lower. The biggest outstanding question is what will the Federal Reserve next do to cap the momentum of the U.S. dollar. The dollar's persistent strength is by far the dominant theme in foreign exchange and all analysis must start from this reality.

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The U.S. dollar breaks out…

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…hitting a fresh 3-year high as it trades above presumed upper bound from QE2

Source for charts: FreeStockCharts.com

Be careful out there!

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.

Additional disclosure: In forex, I am long the British pound