Trading the Pound

by: Ralph Shell

The pound has had a nice run versus the USD this year. From a January trade under 1.54 it has run all the way to the top side of the 1.67 handle. Currently we are trading at 1.6160, about a 38% retrace from the top.

Much of the bullish enthusiasm from traders is linked to the CPI which has consistently run above the targeted rate of inflation, 2%. The most recent CPI released Tuesday was 4.5% y/y. Even the core y/y CPI was up 3.7%. Specs have been long the pound, about 35k in the last COT report, probably hopeful that the Bank of England is going to raise their rate. So far they have been disappointed.

"This morning Bloomberg reported comments from the Deputy Governor which reflects the current policy of the BOE.

"The central bank's Deputy Governor Charles Bean said today that allowing a “temporary” period of above-target inflation is consistent with the bank's mandate and is necessary to support the economic recovery."

"The Monetary Policy Committee's chosen approach has been to accept a temporary period of above-target inflation, rather than seeking to hold inflation as close to the 2 percent target as possible at all times,” Bean said in a speech today in Belfast, Northern Ireland."

BOE Governor Mervyn King and his boys on the MPC have been taking criticism because they have failed to raise rates, but their position does make sense. Yes, the recovery in Britain is fragile, and really, is a 25 basis increase in the rate really going to calm unrest in the Arab world where the oil originates, thereby reducing the price. Or what effect would the rate increase have on the increase in global food costs?

Also one of the main beneficiaries of the low rates is the banking industry. Borrow money from the BOE for .5%, and lend it at higher rates, or buy some government notes or gilts and let time be your friend. Many banks have portfolios of dubious quality loans, and time helps them improve their balance sheets. With a sovereign debt crises looming, this may be the BOE's way to prepare the banks.

The Brit's new Conservative Prime Minister Osborne has initiated his austerity program designed to reduce the deficit. Reduction of government spending, reducing the number of government workers, and increasing taxes hardly seems as way to stimulate the economy. The full impact of these policies, in our opinion, has yet to be felt. If such is the situation, it may be a while until there is sufficient positive economic news in Britain which will result in rate increases.

While the fundamentals appear bearish, how much of this is priced into the Market? Further, selling a market after a sharp 500 point sell off is risky. In the case of the pound, there appears to be strong support between 1.6050 and 1.62. The short side looks like the preferred position, but the risk/reward selling at the current price does not seem prudent. The 1.6270 looks like the first resistance level, however the down has been sharp so selling in the 1.6350 area might be a better entry for a new short position.

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