The Sterling is Getting Pounded

My bullish call behind the dollar has been based on many factors. One factor, however, that I did not take into account is the action in the British Pound.

Sure, I track the overnight rates of the UK economy and where fair value of that target should reside but generally speaking, I have kept my comments to the Euro. But as I reviewed my notes yesterday and the charts of the currencies, I noticed something that was quite interesting. First, things technically are breaking down for the Pound. Second, the UK economy is suffering much more than the US economy at this juncture. In between, the Monetary Policy Committee [MPC] of the Bank of England is stuck as rising inflation and falling growth are accelerating from a spread perspective - the proverbial rock and a hard place.

Trading in the Pound has been mediocre, relative to the Euro, over the past year. The Sterling peaked in the fall of 2007 around 2.10 and has not looked back falling into the 1.90 range today, thanks in large part to a RPI rating that was much higher than most expected (more on that later).

As the pound has been falling, the Euro has been moving up, hitting recent highs at or near the 1.60 level before the most recent tumble lower. This relative strength by the Euro vs the pound was for obvious reasons - stagflation and growth prospects. Plus, the market has believed that the BOE cannot raise rates while the ECB can or could at one point. So all of this contributed to the EURGBP cross rate moving from .70 to the .80 area. Now that trade has reversed.

Generally speaking, historically, the Pound has led the Euro in indicating dollar strength was coming. If you look at the cross rate of the Euro/GBP, it is somewhat decently correlated to the dollar index. When the dollar is weak, this cross rate favors the Euro. When the dollar is strong, such as now, it favors the GBP. In terms of the long term chart, the spread between the GBP and the Euro, relative strength wise, is at its widest since the Pound was pushing towards 2.10. As the Euro moved towards 1.60, that spread boomeranged in favor of the Euro. Now it is unwinding again.

The last time we witnessed such a move (i.e. the boomerang), was in 2005, when the Euro tumbled from 1.36 to a low of 1.18 and the Pound fell from 1.95 to 1.70. If we pushed that forward today, in terms of percentages, that would mean that the Euro corrects from 1.60 to 1.36 and the Pound moves from a 2.10 high to 1.79. Moreover, this would imply that the dollar index moves from the current 76 level to 80.

Both of these points argue that the Pound is headed lower. From the quantitative side, the support levels do not look so supportive from here. Momentum models, long term, now argue the sellers have control. This is the first time since the first half of 2005.

Additionally, a very long term trend line, drawn from the lows in 2002, was taken out on this drop down over the past week. 1.90 is a good support point but with the failure of the weekly chart, things look like they will continue to get worse. From a trading perspective, very short term, the currency is oversold. This argues for a bearish perspective still but some moderation in the declines.

Economically, two data points yesterday morning reasserted their might on the currency. First, the RPI came in at 4.4% yesterday morning. This is much higher than the market expectation (near 4.2%) and .5% higher than last month! This is occurring even as the MPC is holding an hawkish outlook and tight overnight policy (I estimate that fair value between prices and growth is near 4.40%).

On the other side, this tight overnight policy has pummeled the local housing market; the latest RICS survey showed that 84% of surveyors reported lower prices.

While this is a four month high, it is also the fourth WORST reading since the survey was founded over 30 years ago. So like the US, this survey is bouncing along the bottom so to speak. If you add in growth expectations of a mere 1% through the end of the year and possibly lower in 2009, things could get worse from here - this would lead to additional pressure on the sterling (since I am looking for better inflation and higher growth for the US in 2009).

So the story here is rather simple. The sterling is being "pounded" lower and the trends all point to it continuing. Shorter term we are oversold and the ability of the Euro to hold the 1.49 area, might support the pound coming back to the long term trend line which resides around the 1.94 level. From there I would imagine that the selling resumes. Overall, a defensive posture in the GBP is warranted.

Disclosure: No holdings at the moment of the securities mentioned

Comments

[dieuwer:]

EUR/GPB is actually up. In a big way (+1.2%).

2008 Aug 13 10:41 AM

[dieuwer:]

Full blown pound crash in progress (-1.6%)

2008 Aug 13 11:22 AM