The British Pound Surges: What Really Happened (And What Is Likely To Happen Next)

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Includes: EWU, FXB, UDN, UUP
by: Andrew McElroy

Summary

Sterling sure liked the announcement of a snap UK election on June 8th.

Game changer? More like short squeeze.

Why I think GBPUSD could trade to new lows.

Sterling (NYSEARCA:FXB) surged this week, causing the FTSE 100 (NYSEARCA:EWU) to fall sharply. This article looks at some of the reasons behind the volatility, and presents some ideas on what is store for GBP (specifically GBPUSD).

The Official View

On Tuesday morning the British Prime Minister, Theresa May, announced plans for a snap election on June 8th. This surprised the market as last year May repeatedly said there would be no election before 2020.

The market makes large moves on anything it has had no chance to price in. Here is how GBPUSD reacted:

Note the 100 pip drop before the 390 pip spike higher. Was it good news, was it bad? Does it even matter?

Well markets like certainty and it looks almost certain the Conservatives will win.

As Nomura noted yesterday,

'Historically, politicians have not called snap elections without knowing with a high degree of confidence the outcome.'

May could walk the elections, strengthen the Conservative majority and approach the Brexit negotiations without the pesky distraction of opposition.

Judging by the reaction to the announcement, this is all a plus for Sterling, but HSBC is less convinced:

Sterling has reacted positively in the first instance to this news. However, our FX team is not convinced: we see this sudden announcement as just another symptom of the uncertainty in UK politics at the moment - and not a particular reason to buy or sell the currency. Indeed, it is not clear what this means for the Brexit negotiations.

Some Fuel For The Fire

One thing HSBC and Nomura and the majority of analysts won't tell you is that the news was a great excuse for a massive short squeeze. Speculators had been steadily increasing their short bets inside what looked to be a bearish consolidation in the likes of GBPUSD. During March the Sterling spec short positions reached record levels.

So what happens when resistance breaks and price is surging higher for reasons you (and HSBC) can't really understand? You buy back your shorts as fast as you can and ask questions later.

The announcement was a surprise to many, but the way GBPUSD was coiling below resistance suggests some traders were anticipating a break higher. I won't go as far to say they knew what was about to be announced, but the cycles last week clearly showed impulsive buying. Easy to say in hindsight, I know.

Let's get onto the hard part. What next?

Cable Outlook

While news of a snap election is generally positive, the Sterling response to it has been exaggerated by the short squeeze. Consequently, the media's reporting has also been more bullish than is perhaps justified. When the dust settles, Brexit is still a big weight on GBP.

Also consider the broader falls in the US dollar and the Euro (due to Frexit) are making Sterling look good by default. Dollar bulls were over optimistic of the new administration at the beginning of the year, but the situation is nearly at the opposite end of the scale. Trump will eventually get some inflationary policies through.

With this in mind, here is my view of the long term Elliott Wave cycles in GBPUSD:

The decline from the 2007 highs is taking the shape of a large ABC pattern. Wave C will be equal to wave A at around 1.1 where a multi-year bottom could form.

The pattern is fairly similar to the decade long decline from 1992-2002.

I expect the short term rally to reverse from around 1.33 (the 38.2% Fibonacci retracement of the last cycle down) and make its way down to a lower low. I have been long since last October just after the crash, and plan to exit just above 1.3. It's been a long hold for a measly 500 pips, but I don't want to hold during the next decline.

Conclusions

Sterling isn't a sell quite yet, but it's not a long term buy here either. The implications of the election may not be as significant as the immediate reaction suggests.

GBPUSD could make new lows towards the end of 2017.

Disclosure: I am/we are long GBPUSD.

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.