Newton's 3rd law of motion states that for every action there is an equal but opposite reaction. As the British Pound (GBP) is hurled against the wall of 1.62, the force at which it was thrown appears insufficient for it to breakthrough, but rather return to previous levels with similar momentum. Indeed, recent data emanating from the U.K. has been better than expected and has resulted in the British Pound's positive movements, but the cautious policy maintained by the Bank of England (BOE) as well as the 1.62 level may prove a cause of resistance for further upside in the near to medium term.
As such, a short position on (NYSEARCA:FXB) is recommended as GBPUSD falls below the 1.60 level, with a stop at 1.613 (0.79% from current level) and targeting the 1.57 level (1.93% lower from current levels). This position has a risk/reward ratio of 1:2.44.
The Recovery Action
After spending a little over a year and a half growing under 1%, latest figures indicate that the U.K. economy grew at a 1.5% pace year over year as at June 2013. A real recovery finally appears to be under way. The chart below shows the BOE's U.K. GDP figures as well as projections based on constant nominal rates at 0.5% and £375Bn asset purchases.
Expectations going forward for the U.K. economy are modest, with the GDP growth rate estimated at between 1.5% to 2.0% (based on the chart above) for 2013 given a moderate but persistent expansion in global demand; the sustained stimulus from monetary policy and a further easing in credit conditions aided by the Funding for Lending Scheme and steps to increase the resilience of U.K.1 banks & building societies as well as the gradual fading of the impact of the financial crisis on household & business spending.
While the figures in the U.K. are positive, when relative to the U.S., investors should question whether the recent strengthening of the Pound versus the U.S. dollar is warranted. Recent figures show that the U.S. grew 2.5% year over year at June 2013. The Fed's projections on growth for 2013 ranged from 1.8% to 2.4%, with the table below showing the economic projections of the FOMC.
Given the forecasts for the U.S. economy to grow faster than the U.K. economy in the short to medium term, investors may favor USD denominated assets over GBP denominated assets. This should result in higher demand for the U.S. dollar over of the British pound, which should then lead to USD strength over GBP strength in the short to medium term.
Some prognosticators of GBP strength may attribute the increased inflation expectations to improving demand overall. Recent figures show that the U.K.'s CPI is 2.7% year over year in August 2013 and the BOE expects CPI to be around 3% in the near term. The chart below shows the BOE's projections for inflation.
While some ascribed the increased inflation to overall demand and & growth in the economy, the BOE indicated that the 3% outlook on CPI reflected the impact on import prices and the persistent contribution from administered and regulated prices. The higher import prices may be as a result of higher energy prices from geopolitical factors in the Middle East and the regulated prices may be resultant of increased taxes in the U.K. These factors are not supportive of U.K. growth and will negate GBP strength.
Monetary Policy Action
The shift in monetary policy from accommodative to tightening (or even less accommodative) is also a good indication of improved and sustainable economic growth in a sovereign. Both the Fed and the BOE have adopted forward guidance as part of their policies as well as having also engaged in the ubiquitous Quantitative Easing. Furthermore the thresholds that these two central banks are utilizing to shift their policies are broadly similar. These policies are inflation and unemployment. Where the central banks differ are their threshold projections.
Currently in the U.K., CPI is above the BOE's 2% target and unemployment is currently 7.7%, which is above the BOE's 7% threshold. Latest figures in the U.S. show that the PCE Price Index (year over year %) is at 1.4%, below the Fed's 2% target and the unemployment rate is at 7.3%, which is above the Fed's 6.5% target.
Although the U.K.'s CPI is above the BOE's target, the central banks stated that the level is transitory and CPI should return to the 2% region in the following months. However the BOE cited a 55% probability of the unemployment rate falling below the 7% threshold by the third quarter of 2016. The chart below illustrates this.
As seen in the previous table the Fed projects an intention to reach their threshold figures by June 2014 at the earliest. Thus investors can derive that given current conditions the Fed is more likely to reduce their accommodative policy action than the BOE. One can then conclude that going forward the USD is more like to strengthen against the GBP. Hence a short reaction on the recent FXB strengthening action is probably warranted.
GBPUSD is in an uptrend. This trend began from the 1.486 low on June 6th 2013. The price movement formed into an upward trend channel which lasted until September 18th 2013, where it broke through the resistance line of the channel. Some chartists may call this an overthrow. Coincidentally, September 18th 2013 was the FOMC policy announcement and Fed Chairman's press conference. Also the RSI crossed above levels not seen since December 2012. These are also signs of a near-term pullback in the GBPUSD price. The chart below shows the daily price movements of GBPUSD.
If the pullback in GBPUSD ensues, investors can first anticipate a level of support near the 1.57 level, which is where the upward trend line and the 38.2% Fibonacci retracement levels intersect. Given that GBPUSD is currently around 1.60, investors can risk 0.79% (by placing a stop loss order at the high of 1.613) and target an exit around the 1.57 level, a 1.93% move lower from current price levels. This results in a risk/reward ratio of 1:2.44.
Hence a recommendation can be made to short based on both fundamental and technical projections, somewhat proving Newton's 3rd law.
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.