GBP/USD Third Quarter FX Outlook

[B]An Overtly Hawkish Bank of England Drives The Pound To Fresh 26-Year Highs, Will GBP/USD Above 2.0000 Become The Norm?
[/B]The British Pound?s astounding rise into the third quarter leaves many traders wondering whether the 2.000 level will now become new support for the currency.

After reaching fresh 26-year highs of 2.0402 against the Dollar, some analysts see the pair as being top heavy and ready to retrace some of its gains. Interest rates remain the key to further pound strength and with US short term rates having reached their peak, the GBP/USD could hold at lofty levels. Continued spread widening leaves the strong GBP/USD in play, but as heavy 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 through 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. Implied rates predict that the Pound?s yield advantage will continue to grow through the medium term. All other things remaining equal, this leaves risks to the topside across GBP pairs.

[B]Where are Short Term Interest Rates Going?[/B]
Futures contracts currently show that investors expect the Bank of England to raise rates 25 basis points by December. Given the clear tightening bias that the Monetary Policy Committee has maintained since July, many feel that it is only a matter of time before officials opt to raise rates further. There may be significant obstacles to such a move, however, with key events throughout the rest of the year to weigh heavily on market sentiment.
On July 5th, the Bank of England raised interest rates to a six year high of 5.75 percent. The decision was widely expected after BOE Governor Mervyn King was overruled in a 5-4 vote in June, as the majority was in favor of leaving the benchmark steady. With CPI still above the central bank?s 2.0 percent target and house price growth accelerating, there was little doubt that King would be able to convince the other policy makers to take action. Furthermore, the Bank of England maintained their hawkish stance after the rate hike, noting that “the balance of risks” to price stability still “lie to the upside,” leaving the door open to a move to 6.00 percent before year-end.
[B]Can the Economy Handle Another Hike By The Bank of England?[/B]
While GDP has kept pace at a 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. Estimates for second quarter expansion are for a mild slowdown to 2.9 percent, but since the effects of monetary policy tightening take time to filter through the economy, there are major downside risks to third quarter growth. According to Bank of England Deputy Governor Sir John Gieve, this isn?t exactly a problem for the central bank. On July 10th, he told the Nottingham Evening Post: “The issue for me is have we done enough to bring inflation back on a sustained level of two percent in the long term?There are some signs that the past interest rates may be coming through in consumption and housing, but it is not clear cut yet?If we saw a bit of a switch into stronger investment and exports and slightly weaker consumption, that would be no bad thing.” Clearly, the Bank of England is willing to take the risk of slower growth in order to keep inflation in check which tilts the policy bias towards further tightening.
[B]Will Inflation Moderate According to Plan, or is Further Policy Control Necessary?[/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 started to make an impact. In fact, in the Bank of England?s policy statement for July, the MPC said that consumer price inflation is likely to fall back “to around the 2 percent target” this year. Nevertheless, with May CPI readings remained well above that target at 2.5 percent. Therefore, the threat of limited spare capacity in businesses is likely to keep the central bank vigilant.
There are other risks to price stability that have been noted, the first of which is energy prices. With oil prices well above $70/bbl, the second-round effects of energy price increases will continue to be a concern throughout the year. Another major issue has been wage growth. On July 9th, MPC member David Blanchflower said, “Wage growth has been measured?I share concerns about pricing pressures, but it’s a puzzle. We’ve gone through the wage rounds, we know the outcome. It didn’t show up in the data?The data on the demand side appears to be strong?But that hasn’t translated into higher pay.” With the claimant-count unemployment rate down to a nearly two year low of 2.7 percent and signs continuing to emerge that the labor market is tightening, it has been surprising to see average earnings (excluding bonuses) growth actually decelerate to 3.6 percent in the three months to April. Finally, money and credit growth remain a hotly debated topic at the Bank of England, as the jump in UK M4 money supply to 13.9 percent in May is reason for concern. Indeed, the figure is dangerously close to the 16-year highs reached last September, but it is not entirely clear whether this is due to an actual influx in bank lending to consumers (which can be controlled by monetary policy), or if it has more to do with the massive credit expansion sparked by hedge funds, private equity funds, etc. (which is less easily affected by central bank policy).
[B]Housing Shows No Signs of Slowing, Will Current Interest Rates Make An Impact?[/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. One can certainly argue that stronger home prices allow the consumer to extract home equity for increased consumption. Looking at the BoE mortgage data, UK home owners withdrew £13.2 billion in home value through the first quarter of 2007? and while this represents a slowdown from the quarter prior, the figures are still near the 2004 highs. The risks to overheating consumption are undeniable. In fact, equity withdrawal peaks in late 2003 preceded a pronounced slowdown in house price inflation and a moderation in consumption growth. Meanwhile, evidence that current interest rates are starting to make an impact are finally starting to emerge: according to the central bank, Mortgage Approvals have fallen significantly from November?s multi-year highs. 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 has held within a 150 point range throughout the second quarter, as outlooks for Euro Zone and UK interest rates have generally kept pace with each other. With markets betting that both the European Central Bank and Bank of England will raise rates further through the medium term, the EUR/GBP range has little chance of fading. Nevertheless, with the pair still above its 10-year average of 0.6607, Euro-zone demand for UK products has improved quite a bit. In fact, the UK trade deficit unexpectedly narrowed to the best levels in nearly a year, as exports to the Euro-zone picked up. This has also been reflected in output results, as the slowly recovering manufacturing sector showed production expansion of 0.4 percent in the month of May and 1.0 percent growth from a year earlier. Looking ahead, it will take an unexpected shift in ECB or BOE sentiment for the EUR/GBP pair to make a sharp break from recent ranges. As a result, traders should watch inflation reports from both regions, as this will be the best gauge for judging the future direction of interest rates.
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 still above the bank?s 2.0 percent target, market expectations will hinge on upcoming CPI data on July 17th, and reactions in implied yields will likewise have a tremendous impact on the GBP/USD. One only needs to look at historical yield spreads to know that they are one of the most important factors in currency valuation. As such, our outlook for the Pound is admittedly mixed, but with such strong resistance looming above, even the most minor softening in the Bank of England?s tightening bias could lead the currency lower in the third quarter.
[B]Technical Outlook[/B]
Similar to the EURUSD, there are 2 counts that we are tracking in the GBPUSD. The first count has Cable completing a 5 wave rally from 1.7047. The 5th wave is unfolding as an ending diagonal but price must top now (before 2.0570) so that wave 5 of the diagonal (beginning at 1.9621) is not longer than wave 3 of the diagonal (1.9182-2.0131). If Cable tops before 2.0570, then a return to the origin of the diagonal at 1.8515 is possible. If 2.0570 is broken, then Sterling is likely to extend towards the 161.8% extension of 1.9182-2.0131/1.9621 at 2.1157.
[B]GBP/USD Daily Chart (Source: TradeStation 8.2)[/B]