From the September 01, 2012 issue of Futures Magazine • Subscribe!

Pound at critical technical crossroad

Forex Trader

Fundamentals for the British pound seem to be going from bad to worse, yet the currency remains well above key support levels. How long will the British currency continue to remain supported in the face of a double-dip recession and multiple rounds of quantitative easing?

The Bank of England’s latest quarterly inflation report has issued yet another downgrade in growth prospects; 2013 GDP has been revised to zero growth from the 0.8% predicted in the May report. The Bank of England reiterated its forecast that the Consumer Price Index would reach its 2.0% target before year-end from its current 2.4%. 

The pace of decline in UK inflation nearly is identical to that during 2008/2009. CPI peaked at 5.2% in September 2008 before tumbling to 1.1% one year later. The pattern repeated when CPI made another September peak of 5.2%, this time in 2011. If the pace of CPI decline remains in tandem with that of 2008/2009, then we could see inflation reach as low as 1.1%-1.5% before year-end, rather than the 2.0% anticipated. 

One fundamental factor standing apart from 2008/2009 is the decline in energy prices. Unlike in 2008/2009 when oil prices plunged by more than 50%, a double-dip of 30% occurred in 2011 and 2012. Yet any decline in energy is more than offset by the 36% increase in wheat prices and 23% increase in corn so far this year. This would offset the negative impact of slowing energy prices, especially as the sterling index is off 14% from its May highs. 

Aside from comparing inflation and energy prices, bear in mind the Bank of England’s balance sheet has reached a new high of £376 billion, up 54% from autumn 2011. “Paying down inflation” shows the inverse relationship between the increase in the balance sheet and the sharp retreat in inflation from 5.2% to 2.4% during the same period. As inflation nears the 2.0% level and the UK economy shows little signs of exiting recession in the midst of intensifying austerity and slowing global macro dynamics, the case for further QE should remain — as would a challenging forward-looking dynamic on the British pound. 

In July 2012, the Bank of England announced its third round of QE by pumping an additional £50 billion into the economy, rendering the total size of the QE program £450 billion. The original program began in March 2009 with £75 billion, followed by £200 billion later that year. Then in October 2011, the Bank of England delivered a further £75 billion program, which was extended again in February by £50 billion.

As QE reaches the risk of diminishing returns, the Bank of England already is mulling new ways of intervention, such as cutting the base interest rate from its current historic low of 0.5%, or more electronic money printing. On the growth side, the National Institute for Economic and Social Research warned economic growth would contract by 0.5% this year and grow by only 1.3% in 2013. 

Technically, GBP/USD faces a rare confluence of resistance with the 200-day moving average at 1.5730 near the 200-week moving average of $1.5710. That both the 200-day and 200-week moving averages have acted as visible trendlines raises the relevance of this level, and reduces the market’s determination to extend bids beyond 1.5770, which is near the 100-day moving average. 

A breakout above 1.5770 (needed to see a weekly close above 1.5780) sets the next target at 1.5920, the 100-week moving average as of Aug 10. Such a move would be viable only in the event of a new “explosion” in risk appetite, courtesy of a third longer-term refinancing operation (LTRO) from the European Central Bank and a third QE. 

On the downside, a break of support at 1.5480 is the required target by  bears to step up any fresh selling. A weekly close below 1.5480 could pave the way toward 1.5280 as the focal point for the next selling pressure.

Ashraf Laidi is chief global strategist at City Index-FX Solutions and author of “Currency Trading & Intermarket Analysis.” His “Intermarket Insights” appears daily on AshrafLaidi.com.

About the Author

Ashraf Laidi is chief global strategist at City Index-FX Solutions and author of “Currency Trading & Intermarket Analysis.” His Intermarket Insight appears daily on AshrafLaidi.com.

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