[B][B]British Pound / US Dollar Monthly Technical Forecast[/B][/B]
The GBPUSD rally from the January low has carried price to the 50% retracement of the decline from 2.0400. Although deep, the retracement is still in the confines of an acceptable 4th wave correction. Bolstering the reversal scenario is the shooting star candle pattern (circled).
The British Pound/US Dollar currency pair followed the declining interest rate expectations for the BoE lower after policy maker’s decision to add to their quantitative easing efforts. Overnight index Swaps saw a drop in yield forecasts from 114 to 85 bps for the U.K. which narrowed the spread by 16 despite falling U.S. expectations. The central bank expects inflation to remain below its 2% target and lending institutions to restrict credit over the near-term which could threaten any potential recovery.
Improving fundamentals continue to keep expectations elevated and until we see a plateau in their improvement downside risks could be limited. However, if policy maker’s fears come to fruition and activity levels start to recede, a subsequent decline in yield expectations could drag the sterling lower.
[B][B]British Pound / US Dollar Valuation Forecast[/B][/B]
[B]GBPUSD Valuation Forecast: Bearish[/B]
The value gap between British Pound spot and PPP-implied exchange rates has narrowed a bit from the previous month but still stands at a formidable 1616 pips. Yield expectations appear to be the primary catalyst at work right now: a trade-weighted index of the Pound’s average value topped out on 08/05, the day before last month’s surprisingly dovish Bank of England rate decision, and has been trending lower ever since; the Credit Suisse index gauging traders’ 1-year BOE rate hike expectations topped out on the very same day. Indeed, short term (30-day rolling) correlation studies show that the relationship between GBPUSD and the MSCI World Stock Index has weakened to virtually nil at present having stood at close to 84% at the beginning of August. Median economic growth expectations suggest the UK will underperform the US by 1.43% through the end of next year, suggesting the greenback will maintain a relative yield advantage over sterling in the eyes of currency traders. If interest rates are to remain the focus through September, the British Pound may be looking at a major downward correction ahead.
One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.