GBP/USD Is Likely Oversold

by: Hedge Insider

The pound sterling has suffered relative to the United States dollar recently.

In the author's opinion, the pound has been oversold, and is now likely to stage a short-term recovery.

This prediction is made on the basis of improving interest rate differentials, relatively low trailing volatility (notwithstanding the steady sell-off in the GBP/USD witnessed recently).

The FTSE 100 is also holding up as of recent, relative to the S&P 500. This signal, together with the improving rate spreads and low volatility, spells the potential for a short-term breakout to the upside.

The author's recent article, titled GBP/USD: Upside Potential Is Building, identified brewing upside potential in the GBP/USD pair. However, levels of 1.27980 and 1.26700 were also identified as potential targets before such upside potential would likely materialize.

Perhaps unfortunately, the GBP/USD pair has since fallen below the lower level outlined, to around 1.26. At this juncture, we now must ask ourselves if the GBP/USD offers an attractive risk/reward (on either side; long or short). In the author's opinion, the pound sterling is now likely oversold, most importantly on the basis that yield differentials are exploding to the upside.

A currency becomes more attractive to foreign buyers when the underlying carry grows; i.e., if the interest rate offered by one currency rises relative to that of another competing currency. In this case, we are talking about the pound sterling (and the yield on UK debt) versus the United States dollar (and the yield on US debt). The yields on each currency's respective government bonds may serve as proxies for the currency pair's net carry.

The chart below demonstrates that the pound sterling has dropped below the aforementioned level of 1.26700, into the region of 1.26. Yet, the difference between short-term UK government bond yields and yields on their United States counterparts is rising. That is, both in terms of two-year (red line) and one-year (green line) rate spreads. (The spreads are shown on the second y-axis on the far right.)

GBP/USD Yield Spike (Chart created by the author using charting tools. The same applies to charts presented hereafter.)

It is important to caution that the yields are still negative. Nevertheless, the quick spike recently would actually demonstrate a confidence increase in the UK versus the United States, speaking in purely relative terms. And the recent spike is also made in the context of already gradually improving interest rate spreads.

In effect, we have a divergence here between the price of GBP/USD and the underlying interest rate spread dynamics between these two major currencies. In the author's view, the GBP/USD pair has overshot to the 1.26 level (and in fact below, at the recent lows), which would represent an interesting short-term buying opportunity.

These current levels also nicely match up with the "tops of the lows" set back in late 2016 and in the first half of 2017, a trading range whose ceiling was in the same region of 1.26 (see the weekly candlestick chart below).

Weekly Candlestick Chart for GBP/USD

Also, using the same weekly candlestick chart, we can get a gauge on long-term volatility. An interesting gauge is "Bollinger Band Width"; this is effectively the width of trailing 20-period (in this case, 20-week), two-standard-deviation Bollinger Bands. The less overall medium-term price change, the lower the reported volatility will generally be, and hence the lower the reported trailing Bollinger Band Width (see chart below).

GBP/USD Weekly Candlestick Chart: Volatility

In the chart above, I have also added vertical lines to broadly indicate the intermittent lows in the trailing Bollinger Band Width (i.e., times of reduced relative volatility). Of course, we are identifying these points in hindsight, but the point is that subsequent to these temporary dips in volatility, a return to increased volatility usually creates a unidirectional price surge, and often in the opposite direction to the recent price action.

Given that the Bollinger Band Width on the weekly candlestick chart is now quite low at 0.0530, I believe sharper moves are now more likely. And considering that the yields are improving in favor of the pound sterling, it would take a lot of force to shake the GBP/USD price down even further. Therefore, I believe the next move for the GBP/USD will be upward over the coming days and weeks.

One final interesting observation is the ratio between the FTSE 100 (the UK's preeminent equity index) and the S&P 500 (one of the best recognized US equity indices). Notice that when the FTSE 100 is in relative favor (whereby the daily candlesticks in the chart below rise, indicating that the FTSE 100 is outperforming in the immediate term), the GBP/USD will usually follow.

FTSE 100 vs. SPX

A way to think about this is "fast money" flooding into the pound sterling (and UK assets) when UK assets are performing well; when UK assets are apparently in favor and showing relative robustness.

In summary, the FTSE 100 equity index is holding up as of recent, GBP/USD yields are improving, and relatively low levels of volatility are persisting (at least in terms of the 20-week Bollinger Band Width indicator, outlined heretofore). Together, I believe this spells the potential for an "unexpected" near-term break to the upside for the GBP/USD.

Disclosure: I/we 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.