By Sean Hyman
I find that many people come over from the stock market, particularly the U.S. stock market, over into the forex market.
They initially think they don't know a thing about forex. However, if you know some things about stocks and if you have an opinion on where they are headed, then you also likely have an opinion on where the GBP/USD pair is going and didn't know it.
When traders take upon "above average risks" to try to gain "above average returns" they move out of CDs and bonds and into stocks.
However, in currencies when they want to do the same, they move on to currencies that are viewed to be a bit riskier due to their volatility. The pound is one such currency.
So when traders/investors around the world are willing to take upon additional risks for hopefully additional gains, they tend to buy up the British pound as they "dump dollars". This helps the GBP/USD pair.
Also, when stocks plummet and traders abhor risk, they drop the GBP/USD pair like the plague too.
As go stocks, so goes the pound!
See the chart below and you'll see how tight this correlation is. Keep in mind that this is a 3 year chart and not just a short time period where these two happened to coincide.
So now, you likely have an opinion on GBP/USD even before you know the first "fundamental thing" about the U.K. economy.
Now that we know there’s a tight correlation, lets take a look and see which way the latest fundamental and technical data leans!
You’ll quickly see from the screen shot below that BOTH the manufacturing and services sectors in the U.K. have picked up and broken back up above the 50 “boom/bust” level. This means that that manufacturing and their services sectors are now growing/expanding once again.
Then when you look to the fact that it’s got one of the highest year over year inflation rates, you know that it would be one of the earlier ones to raise interest rates. Well, investors love the thought of earning more interest on their money, especially if economies are stabilizing once again like we saw in the above data.
When you look to the chart below, you can see that the U.K. has the 2nd highest inflation rate of the major economies. Therefore, they (along with New Zealand and Australia) will likely be among the first countries to raise their interest rates to “tame” inflation so that it doesn’t get out of hand. These anticipated higher yields will attract capital to all three of these currencies. It will likely also flow away from those countries that still have the deepest deflation (U.S. and Japan) to these higher inflationary countries.
This again, helps the case for GBP/USD’s upside potential.
Yesterday, news also came out that the Bank of England may end its five month bond purchase program (better known as Quantitative Easing) as their economy shows these signs of emerging from the recession. This is where they pumped 125 billion pounds (equal to 10% of their GDP) into their economy.
The Technicals confirm the Fundamentals!
And what better time to take a look at GBP/USD than when it’s broken out from a sideways consolidation within its larger uptrend.
I believe the old Wall Street saying to be true...”the trend is your friend”...and another like it, “trade the trend until it ends”. Therefore, it’s a higher probability that GBP/USD will rise over time than fall.
You can see this from the chart below. See the direction of the 50 day simple moving average. It’s headed upward. So the pair is moving upward overall. Therefore we should place the odds on our side and trade “upward” too by being a buyer of GBP/USD.