British Pound: How Much Further Can it Rise?

The British pound is trading at 15 year highs and the burning question on everyone’s mind is “How Much Further Can it Rise?” In our opinion, quite a bit. The last time the currency was trading at this level against the US dollar was right before the country’s withdrawal from the Exchange Rate Mechanism (ERM) and things were much different then than they are now. The UK economy is now on a far stronger footing with a low risk of a major reversal.

The prior strength that we saw in the British pound in the early 90s was for no reason other than the overvalued fixed parity rate against the deutschmark that Britain had undertaken as a part of the entry into the ERM. We all know how disastrous that turned out to be with the infamous Black Wednesday occurring two years afterwards.

Surge in Inflation will Force the Bank of England to Raise Rates

This time around, the rally in the British pound has been triggered by the currency market’s obsession with countries that need to increase interest rates. For the first time ever, Bank of England Governor King has written an open letter to the Chancellor of the Exchequer Gordon Brown explaining why inflation has surged beyond 1 percent of their target rate. This morning, annualized
consumer prices for the month of March hit 3.1 percent. Full letter available here:

Brown credits the move to the rise in food and energy prices as well as the near 10 percent jump in home furnishings. The housing market continues to perform well with the latest reports revealing increases in house prices. Such strong demand has led many businesses that are tied to housing to increase their own prices as well. The BoE continues to back their belief that consumer prices will drop significantly over the next few months and fall below their 2 percent target by the end of the year. However, with oil prices holding steadily above $60 a barrel and the economy still performing well, the only way that this can be achieved is through a strong currency and higher interest rate. We fully expect King to back his words with action. The futures market is already pricing in a quarter point rate hike in May, as well as another rate hike in the third quarter, which would bring the yield on UK rates to 5.75 percent. The outlook for higher interest rates provides a strong fundamental basis for further gains in the currency pair.

Next Significant High Still 4000 Pips Away

As seen in the Bloomberg chart below, the next significant high in the GBP/USD is still 4000 pips away. On a shorter term basis, we would have to first clear the September 1992 high of 2.0100. Divergence in intraday and daily technical oscillators suggests that there could be a risk of a reversal, but that may just provide an opportunity to buy on dips.

More Data to Spark Gains This Week

With the minutes from the Bank of England monetary policy meeting still due for release along with employment and retail sales data, there are sufficient fundamental catalyst to fuel further gains. The market needs validation that there was a more hawkish voting record at the last monetary policy meeting to confirm that the next move will come in May. If the votes remain at 8-1 with the one dissenter (Blanchflower) still favoring a rate cut, expect to see the GBP/USD slip back below 2.0 like a falling knife because this will signal hesitancy within the policy committee. Any sign of weakness as the currency pair attempts to develop a solid footing above that key level could trigger a wave of profit taking. Therefore we need to first see evidence that the labor market remains strong and consumer spending steady.

Taking Cue from the Euro

Oftentimes traders will get nervous at key psychological levels and wonder whether the currency pair can hold above those levels. A look at the EUR/USD’s past price performance could provide some clues. The last time the EUR/USD rallied above 1.30 from much lower levels was in Nov 2006 and Nov 2004. Both times, a breach of 1.30 led to much stronger gains with virtually little retracement in the days immediately afterwards. Therefore a break of 2.00 could actually be quite positive for the currency in the medium term.