The Sterling Digest: Will the favorable fundamentals continue for GBP?

Written by: Lydia Idem Finkley, Independent trader and blogger at faithmightfx.com



GBP fundamentals have been a beach. Can this change?


Six months prior to the beginning of 2014, forward guidance was delivered from the Bank of England in Mark Carney’s historical, inaugural year as Bank of England Governor. Based on this guidance, the trend of positive economic news validated the sterling bulls of late 2013. So the New Year started with rosy expectations. And the robustness of the British economy surprised many, even the Bank of England. By spring, the central bank scrapped forward guidance. Positive data painted the Bank of England in a very hawkish light much sooner than they wanted.

“Yes, the economy is growing,” they said, “but it remains tepid still.”

Releases in 2014 have shown a resilient British consumer, falling unemployment and a stable manufacturing industry even in the face of sterling strength. The Bank of England didn’t want to derail this recovery by tightening monetary policy too early. But the central bank soon changed its tune. By March’s Inflation Report, and in several speeches thereafter, Carney acknowledged the strength in the economic recovery, recognized the hot housing market and mentioned hiking interest rates. That was all sterling needed for the market to take GBP/USD to 5-year highs and the EUR/GBP to 2-year lows this year.

As we begin the 2nd half of the year, market participants have to wonder if this favorable fundamental landscape will continue. After revisiting prices above 1.7000 for the first time since 2008, we are in the midst of the 1st significant correction of the year in the GBP/USD. Any corrections to this date had been very shallow. It leads a prudent trader to determine what change in the fundamentals laid out above can turn this correction into a full-blown reversal.

Inflation has always raged in the United Kingdom. It is inflation that historically keeps the Bank of England more hawkish than the Federal Reserve. But inflation recently remains below the central bank’s 2% target. In fact, housing prices have declined all year and the consumer price index is significantly lower than it was just a year ago. While the market has enjoyed the strong economic data year to date, UK data in July was a mixed bag. If softer-than-expected data becomes a trend that would constitute a true shift in the fundamental landscape that could unravel this entire bull rally.

The one thing that can be concluded about Mark Carney is that he is not afraid to change his mind. He’s gone from uber dovish to arrogantly hawkish and back to neutral. His new stance today is that the only signal of an interest rate hike is an actual interest rate hike. Talk about a crisis in credibility! The Bank of England is quietly becoming less hawkish. They are cautious again of being too optimistic on the economy. Given the still tepid GDP, the Bank of England will remain accommodative. Though they don’t mind the strong sterling because it keeps inflation in check, they know manufacturers would embrace a weaker currency.

Verdict: The vagueness of the central bank and lack of guidance makes the market dependent on economic data releases. If data continues to come in soft, sterling weakness will gain momentum. If we hear chatter of a dissent to rate hikes, I believe this will be the undoing of the sterling rally. The Bank of England is likely stay on hold longer than the market expects… until they don’t.

Read The Sterling Digest out every 2 weeks on www.faithmightfx.com!