Improving economic data is a major factor in the rally of the British Pound.
The Bank of England (BOE) has choices to make, which will affect the U.K. economy and the British Pound based on the economic data.
The anticipation of a wrong choice will cause a decline in the British Pound by over 1% in the next three months.
The Chosen Path - Three Month Outlook On The British Pound
Some believe in fate, that is, the development of events outside a person's control, regarded as predetermined by a supernatural power. Others see things differently. Some think that the element of choice is fully in one's control. A more mathematical approach to fate and control is envisaged resembles binomial option pricing.
Source : Virginie Joly-Stroebel
So - Person or committee that is making the decision
p - Probability that a decision will be made
q - 1-p, the probability that a decision will not be made
t - Time over all the decision making periods of person or committee
n- Number of choices/decisions that are made by person or committee
r - The general average market rate of outcomes given by the supernatural power to powers and committees
Ϭ - The rate of outcomes given by the supernatural power to the specific person or committee
As UK economic data points keep meeting and beating expectations the BOE has choices to make. The central bank has to decide on shifting its policies from accommodative to tightening by reducing its asset purchases and raising its benchmark rate. With the British Pound at multiyear highs, any ill-timed decisions from the BOE will pullback the currency from those multiyear highs. As such investors should consider reducing their positions in British Pound denominated assets or hedging their positions with a short (NYSEARCA:FXB) over the next three months.
Guidance On Decisions
The BOE utilizes macroeconomic data to aid its decision making. Starting with GDP, the UK's performance has been one of the best out of the developed economies. Real GDP rose 3% year over year for the 1st quarter of 2014. What is also impressive is not only the growth rate but the drivers of the growth, which showed signs of balance in the U.K. economy. On a quarterly basis through March 2014, investment rose 5%, the 5th consecutive increase and also the largest period of expansion in 16 years. Consumer spending increased 0.8%, the 10th consecutive increase while net trade rose 0.8%. The chart below shows the breakdown of the U.K.'s GDP growth.
Chart 1 U.K. GDP Growth (%yoy)
The GDP data gives the BOE the impetus to switch paths in policy. But given the unprecedented moves in monetary policy since 2008, the shift in policy may prove delicate. Given that situation the BOE is also strongly considering the type of inflation in the economy, the slack in the job market as well as the housing market before making a shift.
Surprisingly, unlike the U.K.'s GDP, inflation has failed to pick-up. U.K. CPI rose 1.5% year over year in May 2014 while core CPI rose 1.6%. The inflation measure was the lowest since October 2009 and been at or below the BOE's 2% target for 6 months, the longest stretch since 2009. Drivers of inflation or lack thereof were supermarket price wars which drove food and non-alcoholic beverages down. Along with declines in consumer staple prices clothing prices fell, as did air and sea transport costs after travel operators raised fares in the run-up to Easter in April. Retail-price inflation, a measure used as a basis for the inflation-linked bond market, slowed to 2.4%, the lowest since December 2009, from 2.5%. The chart below shows U.K. CPI.
Chart 2 U.K. CPI Y-o-Y May-09 to May-14
Source : Bloomberg
The lack of upside momentum in CPI places the BOE in a conundrum. An ill-timed move in policy can easily slip the U.K. in a period of deflation as there seems to be no wage pressure, as well as declines in the volatile components in the CPI. Thus the BOE may choose to wait for a sustained increase in inflation above 2% before deciding to unwind QE and tighten.
What also has the BOE anxious to change their current policy stance is the improvement in the labour market. U.K. unemployment fell to the lowest level in more than 5 years, a 6.6% level as at April 2014. The chart below shows the U.K.'s unemployment rate.
Chart 3 U.K. Unemployment Rate (%) Apr-09 to Apr-14
The BOE is anticipating that as the unemployment rate continues to decline and the slack is filled, wage pressure should develop. This move should propel the CPI to move above the 2% level, making the BOE's tightening path an easy one.
Another factor which makes things complicated for the BOE is the U.K. housing market. U.K. national prices rose 1% in June from May, the 14th month of increases. The annual increase is 11.8% the fastest year on year move since January 2005. The chart below shows the Nationwide House Price.
Chart 4 U.K. National House Price Y-o-Y Jun-09 to Jun-14
Unwinding QE and raising the benchmark rate may be the wrong decision to make by the BOE as it may crimp the recovery at hand and put the U.K. in a period of deflation. The BOE should set a path for a more targeted approach to cooling the housing market.
The Technical Chosen Path
The improving U.K. drove the price of the British Pound higher, making levels not seen since 2008. After creating a double bottom formation around the 1.483 region at the end of March 2013 and early July 2013, GBPUSD began its upward trajectory. The chart shows the daily chart of GBPUSD.
Chart 5 GBPUSD Daily Chart
GBPUSD then began channeling from the 4th quarter of 2013 to present. The price momentum indicators entered overbought territories as the rally ensued. Negative divergence was also noticed on the shorter termed momentum indicator.
Chart 6 GBPUSD 4 Hour Chart
While the uptrend remains intact GBPUSD is expected to pull back to the support trend line, a 1.30% decline from current levels over the next 3 months. As such investors should consider hedging their British Pound positions by taking a short position in FXB or reducing their British Pound denominated assets overall.
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