GBP/USD Outlook: What's At Stake for the Bank of England?

After a rough and tumble third quarter that saw the British Pound rocket to 26-year highs of 2.0657 before plummeting 800 points lower in less than a month, the currency has found itself holding on to the 2.000 figure in the early days of the fourth quarter. This strength has been somewhat surprising after UK mortgage lender Northern Rock experienced an all-out bank run, leaving many analysts wondering if there are other financial institutions in distress.

Nevertheless, economic data has proven to highlight a relatively resilient economy that has helped keep the British Pound above 2.0 for the majority of the third quarter. Now that the Bank of England has established that they are not following the Federal Reserve’s rate-cutting lead by leaving their overnight lending rate steady at 5.75 percent on October 4th, it appears that the currency may also be able to hold above that critical level for much of the fourth quarter.
Interest rates remain the key to further pound strength and with US short term rates now moving lower, the GBP/USD could remain at lofty levels. Continued spread widening leaves the strong GBP/USD in play, but since heavy technical resistance sits just above current price, such an outlook clearly depends on the future of short-term interest rates.
The chart below emphasizes the strength of the relationship between yields and currency movements over the past twelve months of trade. The US yield advantage peaked in July 2006, allowing the GBPUSD to set a firm bottom and reverse its previous downtrend. The currency pair subsequently scaled 15-year highs when UK short term rates surpassed their US counterparts through the first quarter. However, with conditions in the UK economy likely to deteriorate in coming months, creating the potential for a decrease in UK interest rates, there remain downside risks across the GBP pairs.

[B]Where are Short Term Interest Rates Going?[/B]
Just a few months ago, futures contracts showed that investors expected the Bank of England to raise rates to 6.00 percent by December. However, with the overnight lending rate currently at a six-year high of 5.75 percent, this is no longer the case as the traders are now betting that the central bank’s tightening cycle has come to end. On October 4th, the Bank of England left rates steady for the third consecutive month as policy makers weighed the issues of upside inflation risks against the potential of a worsening credit crunch. While the rate decision was widely expected, traders were actually waiting to see if the bank would issue a policy statement as they did in September, when they acknowledged the troubles in the financial markets but said that it was “too soon to tell how far the disruption…will impair the availability of credit to companies and households.” Instead, the Bank of England was mum on conditions in the financial markets, signaling that they have no plans to address credit issues with the overnight lending rate. Nevertheless, the release of the minutes from this meeting on October 17th could prove to be crucial to not only the outlook for interest rates in the UK, but price action in the GBP pairs. If the minutes show even a few votes for a rate cut by some of the monetary policy committee members, the markets may judge that the doves in the Bank of England will garner enough votes to actually enact more accommodative policy in November or December.
[B]What is at Stake for the Bank of England?[/B]
While GDP accelerated even further during the second quarter and hit an annualized pace of 3.1 percent – up from the buoyant 3.0 percent in the first quarter – the ultra-aggressive stance that the Bank of England has taken this year will surely make a dent on the economy and start to feed through into data released in coming months. In fact, one victim of the rapid rise in short term rates has already been revealed: Northern Rock.
The UK mortgage lender was squeezed during the August credit crunch that rocked the global financial markets, as the bank regularly borrowed for term in the money markets and then used this cash to make long-term mortgage loans. When the news hit the wires that Northern Rock was being “bailed out” by the Bank of England as they requested an emergency loan, an all-out bank run ensued as hundreds of customers lined up to withdraw their savings, ignoring government assurances that their money was safe. The panic gradually died down as the central bank officially guaranteed existing deposits, but Northern Rock is by no means in the clear. In fact, on October 5th news emerged that the trouble mortgage lender had borrowed more than £10 billion since September 12th as Northern Rock, the UK Treasury, and their advisers try to arrange a takeover or other arrangement that will resolve the bank’s future.
On September 26th, the Bank of England announced that there were no bids for additional emergency borrowing for three-month tender. This was taken as very bullish news for the British Pound with investors viewing it as a signal that credit conditions improved dramatically and no other financial institutions are in need of funding. However, it is worth recalling that when there’s one ****roach, there are usually many others that have yet to be discovered, meaning that Northern Rock probably wasn’t the only bank in distress. Nevertheless, if a financial institution had come forward to utilize the funding, the bank’s shares would get a huge stamp of disapproval in the equity markets. As a result, if there are any other troubled banks in the UK, they are highly unlikely to come forward until they are on the brink of collapse.
[B]Has Inflation Moderated Enough?[/B]
Ever since CPI surged to 3.1 percent back in March – prompting Governor King to write a letter to former-Chancellor of the Exchequer Gordon Brown explaining how he planned to bring inflation back to the 2.0 percent target – the Bank of England’s primary concern has been to take an aggressive stand in the fight against inflation. Thus far, the UK central bank’s policy actions appear to have made an impact as August CPI readings dropped below the official 2.0 percent target to 1.8 percent. In its August Inflation Report, the Bank of England monetary policy committee’s central projection was for inflation to remain close to the 2.0 percent target over the following three months and for output growth to ease, reflecting a slowing in both consumer spending and business investment. While manufacturing and service sector indicators have indeed started to show a bit of easing, they still remain quite healthy with their respective PMI levels holding well above 50 (signaling expansion).
Meanwhile, volatile factors remain a major risk to price stability around the world as oil prices reached record highs above $80/bbl in September, and the second-round effects of energy price increases will continue to be a concern throughout the year. Another major issue has been food prices, as the British Retail Consortium noted that prices rose 0.6 percent between August and September – the biggest monthly increase this year – to push the annualized rate of food price inflation to 2.7 percent from 2.1 percent the month prior. Given these major upside risks, the Bank of England has very little room by which to cut rates perchance inflation pressures start to mount again.
[B]Housing Starts To Show Signs of Slowing, Will Current Interest Rates Accelerate The Decline?[/B]
Strong domestic consumption has clearly been one of the driving forces of broader UK growth and underlying inflationary trends. This can be seen through double-digit house price growth over the past year, with the HBOS Housing Index printing at 10.7 percent through its most recent read. It can certainly be argued that stronger home prices allow the consumer to extract home equity for increased consumption. However, looking at the BoE mortgage data, UK home owners withdrew £10.0 billion in home value through the second quarter of 2007, a significant slowdown from the quarter prior and a possible signal that consumer spending growth could start to ease. In fact, a peak in equity withdrawals in late 2003 preceded a pronounced slowdown in house price inflation and a moderation in consumption growth. Additional evidence that current interest rates are starting to make an impact is emerging as well: according to the central bank, Mortgage Approvals have fallen significantly to 109,000 from the November 2006 multi-year highs of 128,000. Though such a drop could prove temporary, risks seem weighed to the downside on reports of overall declines in house-purchasing activity.
[B]The Euro-Sterling Exchange Rate Aids UK Manufacturers, Will The BOE and ECB Outlooks Change This?[/B]
As for EUR/GBP, price action held within a 150 point range throughout much of the third quarter, as outlooks for Euro Zone and UK interest rates have generally kept pace with each other. However, EUR/GBP broke higher in mid-September to hit multi-year highs of 0.7031, as the markets suddenly weighed the odds of whether the European Central Bank or the Bank of England would cut rates in the medium term. As a result, the typically range-bound pair has become quite volatile. Nevertheless, the UK looks to benefit from the depreciation of the British Pound against the Euro, especially as demand from the Euro-zone has improved quite a bit over the course of the year. In fact, since April, the UK trade deficit with the Euro-zone has narrowed to £2.084 billion – the best level in nearly a year. Looking ahead, it appears to be only a matter of time before the ECB or BOE cuts rates, however, it is unlikely to occur before year-end and could leave the recent EUR/GBP uptrend intact. As a result, while UK manufacturers may see domestic demand slow somewhat, exports to their neighbors in the Euro-zone could help keep the sector relatively healthy.
Ever since CPI jumped over the 3.0 percent inflation ceiling, the Bank of England has taken a staunchly hawkish stance, driving interest rates to a six year high of 5.75 percent. With CPI now below the bank’s 2.0 percent target and the UK banking sector remaining on edge amidst a lingering credit crunch, the Bank of England has been dealt a difficult hand. Now that the Federal Reserve has given in and cut rates, investors are speculating that the UK’s central bank will follow suit. However, Bank of England Governor Mervyn King is known to be an ardent hawk who stands firmly against enacting policies that have even the slightest chance of creating the risk of moral hazard. One only has to look at historical yield spreads to know that they are one of the most important factors in currency valuation, thus, if we see the Bank of England hold their ground while the Federal Reserve continues to cut, the British Pound could continue its ascent toward 2.05. On the other hand, signs that the UK central bank is moving towards a more dovish stance could be the trigger to send the national currency crashing lower against the US Dollar. As such, our outlook for the Pound is admittedly mixed, but with risks looming both to the upside and downside, classic interest rate differentials may underpin a bid for the currency through the remainder of the year.
[B]GBPUSD Technical Outlook[/B]
Similar to the EURUSD, the rally from the 2006 low is choppy and warns of a reversal. However, Cable remains well bid as the pair holds within a rising trend channel from the June 2006 low. The resistance line from this channel is just above 2.1000. A GBPUSD rally to 2.1000 or so fits nicely with a EURUSD rally to 1.44/1.4500 before a reversal of significant proportion. A weekly close below the mentioned channel would signal that a top is in place. Monthly RSI is approaching 70 (at 69.5 right now) and is divergent with the highs made in 2004. Since 1979, monthly RSI has signaled overbought 6 times. Once a top was established, the smallest decline was 1,100 pips. With this in mind, watch 2.1000 carefully (if price does not indeed reach there).

[B]Written by DailyFX Research Team[/B]