GBP/USD: Waiting For The Turn

Includes: ERO, FXB
by: Nicholas Kennedy

GBP/USD should struggle beyond 1.6100/40, so you should watch for signs of a reversal. Sterling’s climb from the lows, sub GBP/USD1.5300 touched at the start of the month, has been quite impressive, with the unit holding just under the 1.6000 level currently. Unfortunately this hasn’t been due to any particularly positive UK developments, rather the recovery has been on the coattails of a resurgent euro as investors piled in behind the view that policy makers there finally ‘get it’ and a credible solution was now in the works there. Of course such a scenario is essential for the UK too given that around half the country’s exports head for the single currency zone, but not enough in our view to warrant any substantial re-rating of the pound.

Examining UK dynamics more closely, things are looking increasingly tough. Inflation hit 5.2% year/year in September, (mkt 4.9%) and although nasty base effects were partly to blame it’s difficult to deny that there is a problem, underlined by rising inflation expectations, even if the headline rate does finally begin to moderate. This might normally be expected to help erode debt, but wage growth is paltry with the fall in living standards well documented and the unemployment rate rising again, something not lost on the consumer with both the Nationwide (Sept. reading 45.0 from 49.0 in Aug) and GfK (-30 vs. -31 in Aug) confidence surveys stuck in the doldrums. It’s not just consumers though; the PMIs showed manufacturing slipping into contraction over the summer while construction also continues to weaken. Only services have shown any resilience and the sustainability of that is questionable given income pressures and tightening fiscal policy. This should all be evident next week in the advance Q3 GDP print. Although NIESR estimates 0.4-0.5% growth recent performance and shocks over the summer (weather included) suggest this is optimistic.

Bank of England moves are equally telling, including the additional dose of QE (increasing the programme from £200bn to £275bn) accompanied by cautious rhetoric as to the economic outlook. Beyond, that there have been calls for the government to show flexibility with regard to its fiscal consolidation. This was dismissed out of hand. It is after all the lone source of credibility left in the eyes of the market, even if the pledged budget targets look like fantasy with the economy teetering. One metric worth keeping an eye on is the performance of gilts vs. bunds. While German paper outperformed amid flight to quality demand as the debt crisis flared, Deutschland’s credit worthiness is increasingly being called into question based on the assumption that it will have to bear a disproportionate cost of expanded bailouts. If we see UK yields begin to underperform vs. the German curve digesting this risk it might be an ominous sign. For reference, 10-year spreads between the two sovereigns are currently +42bps from closer to 60bps at the start of the month.

The currency looks equally exposed, particularly given that economic performance may force the BoE to inject even larger quantities of cash into the economy via its inefficient QE channel. This should weigh on sterling pressure that would become even more intense if markets begin to question the viability of the fiscal project too. The EUR/GBP chart still looks like an uninspiring way to play this; however looking at cable we think the market will struggle to make much headway higher, the GBP/USD1.6100/40 area is really the very top of the recovery rally. Medium term we continue to believe that GBP/USD should be able to push down through the September lows sub 1.5270 and would keep a close eye on indicators such as the MACD for sell signals. Even those with a more constructive view would be better served by patience, there being room for even a short-term correction to tag back to the 1.5785 area if initial daily support at 1.5920/40 fails.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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