A little over a year ago, I reluctantly dropped my bearish bias against the British pound (NYSEARCA:FXB). A week after that change, I transformed into an unapologetic sterling bull after reviewing the economic indicators from the Bank of England's Inflation Report at that time. I called the pound a bargain.
I could not know it at the time, but this call turned into one of my most reliable and consistent trading calls over the next 12 months (until recently, closely rivaled by my bearishness on the Canadian dollar). I only faced one challenge to my conviction of a bottom for the pound against the U.S. dollar. That challenge was particularly difficult because it came immediately after a timely and sharp rally for the pound seemed to confirm my trading call.
The British pound made a classic breakout from a downtrend that has delivered one of the stronger trends for 2014
My call for a bottom received a serious gut check in less than two monthsSource: FreeStockCharts.com
Eleven percent higher and a broken downtrend later, it is time to drop the bullish bias. It has been a great run buying dips, but I think a lot of the good fortunes coming for the UK economy in the short to medium-term are just about fully priced into the pound. The last Inflation Report provided some hints that the Bank of England may even reach a point of intolerance on the strength of the currency. Moreover, the European Central Bank's imminent efforts to fight deflation will encourage, even force, central banks across Europe to build walls to slow down, if not outright prevent, pressures for currency appreciation. The next plunge in the euro could provide the beginning of the end for the rally in the pound.
Carney raises a brow against sterling
In his introductory remarks to the Inflation Report, Bank of England Governor Mark Carney pointed out that exports are facing a currency headwind (emphasis mine):
"The time taken to absorb spare capacity is a reflection of the continued headwinds faced by the economy. The financial sector continues to heal. Public and private balance sheets continue to be repaired. Export growth faces a 10% appreciation of sterling over the past year. And growth in the world economy remains muted."
Carney goes on to suggest that the strength of the currency is a transitory phenomenon:
"The global picture is consistent with muted external inflationary pressures that, coupled with sterling's past appreciation, will moderate CPI inflation in the near term. Inflation has fallen sharply since the Autumn and is now around one percentage point lower than we had expected a year ago. We have interpreted this news largely as the result of one-off factors rather than lower underlying inflationary pressure."
Note well that Carney does not directly say that the strength in sterling is a one-off factor. He implies it by the vicinity of his words and his failure to list any other one-off factors.
Carney was clearer and more specific during the conference call when he answered a question from Bloomberg Television's Jonathan Ferro on the disinflation risks posed by a strong currency.
"Well, two things on the exchange rate. I think the first is that - just to pick up my last answer - is this Committee rightly looked through one-off effects from the depreciation of the currency post the crisis that pushed inflation above target. We have taken into account the impacts of the recent appreciation, but we will largely look through those impacts in terms of setting monetary policy. So inflation is lower in part, as you say, because of the strength of sterling."
In other words, Carney acknowledged that the strong currency is helping to cause a lower than desired inflation rate, but the BoE does not think the impact warrants its attention. The currency should lose altitude in due time.
"The second thing I'll say is that, you know, the movements in exchange rates in the recent past have reflected differences in the strength of recoveries, and the UK recovery has been stronger than some others, albeit from a very low base, it has been stronger. Persistent strength, persistent strength of sterling, will challenge the balance of the expansion."
The last sentence caught my attention. It put me on notice. Given the Bank of England is on high alert to ensure the health and progress of the economic expansion by preventing a pre-mature run-up in interest rates, I can only assume that the longer the currency remains this strong, the more attention the BoE will direct toward it. In other words, time is ticking on the pound at these levels.
Phil Aldrick from The Times pressed the issue on the definition of "persistent strength." Carney responded with additional details:
"Clearly the exchange rate is always an important relative price for an economy as open as the United Kingdom's. We distinguish between level effects of movements in the currency, level effects on inflation, so in other words the pass-through of changes in the currency that can be quite large. We certainly incorporate those in our forecasts; in fact it's one of the drivers of the near term forecast for inflation in this Report. We distinguish between that and the real effects that flow through the economy.
Those real effects require persistent changes, that's why I emphasised that. And what we can commit - and what we will follow through on - is we will use our speeches, our press conferences, our analysis and Inflation Reports to bring out those effects in terms of our forecast and the balance on forces for both output and inflation."
In other words, if the currency's strength persists, the Bank of England will certainly attempt to talk down its value. For example, the BoE could move from simply calling the currency strong to "over-valued" or inappropriately priced given the prospects for recovery, etc.
"We do need - the last point - we do need more balance during the expansion in terms of the drivers of growth. We will not - the expansion will not endure through household spending. That requires business investment and ultimately will require some recovery in net exports. First and foremost for that recovery is going to be an improvement in productivity, but clearly persistence, level of exchange rate will be relevant to the speed with which that happens."
The Bank of England is likely hoping that productivity gains will eliminate the need to worry about the currency's value. Since the recovery needs a healthy export sector, sluggish productivity combined with a strong currency will sour the economic outlook. I will be keeping an eye on those productivity assessments.
The imminent pressure from the euro
European Central Bank (ECB) President Mario Draghi finally reached the limits of his patience with the stubborn strength in the euro (NYSEARCA:FXE). In the last decision on monetary policy earlier this month, he reported that "…we had an extensive discussion that took note that, while the recovery is firming up in some parts of the euro area, at the same time the Governing Council is not resigned to having low inflation for too long a time…at the end of this discussion I would say that the Governing Council is comfortable with acting next time, but before we want to see the staff projections that will come out in early June." The market interpreted the latter statement as indicating the ECB WILL finally act against the appreciation of the euro despite the ECB's firm and persistent conclusion that "medium to long-term inflation expectations remain firmly anchored in line with price stability."
The euro falls in response to ECB suggestions for June action
The euro fell in response to the ECB's suggestion that action is coming in June. However, note that FXE has yet to even challenge the 2014 low, and it remains firmly engulfed in an on-going uptrend from lows set almost two years ago when the ECB convinced markets that the tail risks to the euro had disappeared. I used this opportunity to close out my latest fade on the euro against the U.S. dollar and shortly after that the Japanese yen. Given the potential continuation of downside momentum, I have chosen to rebuild a position with the largest additions coming on fresh (near-term) lows; I have moved from fading to trend-following. If the ECB disappoints next month, and there remains a "decent" chance that it will, I will rush for the exits like every other euro short (and likely revert to a patient fading strategy).
If the ECB follows through with monetary mechanisms that "might even strike the most fertile imagination" as ECB Executive Board member Yves Mersch claimed almost two weeks ago, the resulting plunge in the euro will likely put pressure on currencies across Europe. HBC currency strategist David Bloom made this point in "Macroprudential measures' impact on sterling," the May 22nd podcast from Hard Currency. I think the Swiss National Bank (SNB) will face the largest amount of pressure given the Euro-swiss currency pair (EUR/CHF) continues to trade just above the SNB's 1.20 floor.
A floor in danger?
I am MOST interested in how the Bank of England might respond. The weekly chart below shows the pound has steadily gained against the euro since the financial crisis. I foresee a rapid retest of the 2012 lows. By THAT point, alarm bells should be ringing at the Bank of England and some kind of talk down of the pound should begin.
The road has been choppy yet sure - the pound continues to gain ground over the euroSource for charts: FreeStockCharts.com
All eyes will ultimately turn to the U.S. dollar (NYSEARCA:UUP) to respond to the call for a weaker euro by finally showing some upward momentum. Without an underlying change in direction, the pressure on European currencies to serve as outlets for the eurozone's deflation could get tremendous.
Note well that I have not reverted to a bearish bias against the pound, I am simply not unequivocally bullish (double negative intended). I am probably early in this call by at least a few months, but I have no interest in pressing my luck to its very limits. I think there is enough evidence to suggest that the pound's reliable rally will come to an end sooner than later. Going forward, I will seek out both long and short opportunities as the context dictates. I will also avoid automatic buys on dips on GBP/USD.
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 remain net long the British pound. I am also net short the euro.