The Runway Should Be Rocky For The Pound Until The August Inflation Report

Includes: FXB, FXE
by: Dr. Duru

Second quarter GDP growth in the U.K. met "expectations" with a 0.6% gain over the first quarter and a 1.4% gain year-over-year. This is the first estimate and uses 44% of actual data.

The initial reaction was to sell the British pound (NYSEARCA:FXB). Presumably, expectations were high going into this report with a series of good economic data points in recent weeks, so meeting expectations triggered the obligatory contrary sell-off. However, the pound recovered all its losses in the U.S. trading session as the U.S. dollar fell across most major currency pairs.

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The pound continues its bounce from the lows

In the chart above, note how GBP/USD has roughly held onto support around the 50-day moving average (DMA) since Monday's (July 22) important breakout. Normally, I would conclude that the runway is now clear for further gains, but the next Bank of England Inflation Report is coming in two weeks. Fresh memories remain of new governor Mark Carney's dovish talk after the last monetary policy decision where he called the rise in market rates at that time unwarranted by the economic data. The British pound sold-off sharply at that point (although the pound proceeded to recover quickly starting with a parry of dovishness from Federal Reserve Chairman Ben Bernanke). Expecting more of the same currency-contracting talk in the Inflation Report, I am guessing nervous traders will be reluctant to take the pound much higher from here. Moreover, new resistance from the 200DMA looms directly overhead.

Regardless, I am sticking to the bullish call on the pound versus the U.S. dollar and will wait out what should be a rocky runway approaching the Inflation Report. If the pound can rumble through mostly intact, I think there is a strong possibility for take-off and a fresh rally against the U.S. dollar. The coming volatility should provide plenty of short-term trading opportunities, up or down, on the pound across major currency pairs. If needed, I prefer most to hedge using the Japanese yen (GBP/JPY) or even the Australian dollar (GBP/AUD). (More on the Australian dollar in a future post).

The most intriguing pair is the euro (NYSEARCA:FXE) versus the pound (EUR/GBP).

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The year-long rally in EUR/GBP has returned the pair to the middle of its post-recession range

Source for charts:

Exactly one year ago, the euro finally bottomed against the pound with the rally peaking in March of this year. After a sell-off, the euro has steadily gained against the pound for the last three months. This is important because weak demand from the eurozone has been partially blamed for the U.K.'s poor performance in manufacturing. A weaker pound versus the euro should help U.K. exports a bit. (My short-term bearishness against the euro ended with its retest of 2013 lows against the U.S. dollar).

Manufacturing is one of two sectors (the other being construction) languishing the most in the U.K. economy. The eurozone is a major drag on U.K. manufacturing. Manufacturing is still 10% below its pre-recession level of output whereas services has essentially fully recovered. Manufacturing has declined consistently since late 2010, so its 0.4% growth in the second quarter is a small but encouraging sign of improvement.

To the extent that this week's strong Purchasing Managers Index numbers in France (17-month high) and Germany (5-month high) count for anything, there is additional support for the possibility that U.K. manufacturing is on the mend. It will be interesting to see how much time Carney spends on the positive indicators versus the negative ones given the recent lesson that "too much" optimism could lead to another (supposedly premature) rapid rise in rates.

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. In forex, I am long GBP/USD