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Currency Forecast
GBP/USD Outlook
After undergoing a deep slide in 2005 to a low of 1.7048, the British pound has stabilised in the first quarter of 2006 and has spent the first three months of the year range trading. Interest rate spreads have been the dominant reason for the currency pairs trading range, so it is no wonder that the zero spread between the US dollar and the British pound between January 31st and March 27th has prevented the pair from experiencing any meaningful volatility. Additionally, in the past month, we have seen a major shift in balance between the US dollar and the British pound. For the first time since December 2000, the British pound is offering a lower interest rate than the US dollar. The 25 basis point negative interest rate differential is expected to increase even further to the dollars advantage as the Federal Reserve continues to raise interest rates, which will prove to be a big burden on the GBP/USD. Improving conditions have allowed the Bank of England to lean closer to neutral than in favour of lowering interest rates, but economic data has still been very mixed, which will prevent the central bank from closing the widening interest rate gap by raising interest rates.
Growth Remains Tepid At Best
Believe it or not, economic data has improved in the British economy as housing valuations have stabilised while the manufacturing sector has seen a notable, albeit modest pickup. Over the course of the quarter, consumer spending picked up pace as individuals buoyed by higher wage growth became convinced that the Bank of England had no near term aspirations to increase benchmark rates. Headline wage growth spiked higher by 5.3 percent in the month February. This bullishness has filtered into surveys, including the most recent HBOS Plc report. According to the survey of the $6 trillion property market, prices climbed 0.9 percent to an average of 175,215 pounds ($307,038). This places the annual rate of appreciation to 6.2 percent, demonstrating continued strength after the slight pullback seen over the last three quarters. Subsequently, this stabilisation in the housing sector has weighed heavily on the decision by policy makers in keeping the current 4.5 percent repurchase rate. Additionally, manufacturing activity has recovered modestly, suggesting that the current policy of no rate changes is likely to continue. Accounting for approximately 15 percent of the $2 trillion economy, manufacturing has surprisingly advanced after posting disappointing results for much of 2005. According to the Office for National Statistics, activity in the sector has rebounded to produce growth in the three of the last four months and will contribute heavily to overall growth. Policy makers are agreeing with the positive sentiment as expectations run high that global exports and business investment will foster a growth rate of 2.7 percent this year, above the 1.8 percent rate witnessed last year. Nonetheless, consumer spending remains the key tipping point of the UK economy as individuals continue to be hesitant in the current economic conditions. The employment picture has worsened despite the fact that wages are climbing, and this paradox has led to a very competitive retail environment as retailers compete, offering bottom feeder prices in order to attract market share. The Confederation of British Industrys distributive survey improved in the most recent month to a negative 16 reading from the previous negative 18. The fact that the trades survey continues to print a negative difference reflects a major concern for BOE members as domestic demand contributes to over 60 percent of the economys growth.
Bank of England to Maintain Neutral Policy
The muted consumer spending environment and stable housing market should encourage the Bank of England to maintain a neutral monetary policy for the remainder of the year even though some proponents are calling for a quarter-point cut in the third quarter of this year. Depending upon how the manufacturing and housing sector continue to impact consumer spending, the Bank of England will have to make a decision regarding the need to reduce interest rates. Going into 2006, analysts were predicting two to three interest cuts. At this point, we would be surprised to see even one rate cut over the next two quarters. Nevertheless, the interest rate spread between the British pound and the US dollar will continue to move in the US dollars favour, which could increase the volatility in the currency pair. If you recall, between February and March, the interest rate spread was zero, coinciding with extremely tight trading ranges in the GBP/USD. If the spread moves from -25bp to -75bp, like it is expected to, ranges could also expand in the GBP/USD. In contrast, the range of EUR/GBP, which has recently become a more trending currency pair, could contract with the interest rate spread narrowing as a result of the ECBs much anticipated quarterly rate hikes this year.
M&A And Equity Prospects, More To Come
Throughout the first quarter of 2006, the British pound has received a significant boost from an increase in merger and acquisition transactions in the U.K. Increased protectionism measures in the US have made the UKs business friendly market more attractive to international investors. The most recent acquisition has been US based Nasdaqs 15 percent investment into the London Stock Exchange (LSE). Speculation of additional interest by other global competitors for shares of the LSE has raised the possibility of more M&A activity. Valued at 447.7 million pounds, the acquisition follows on the heels of earlier transactions. Spains Banco Santander acquired Abbey National making a presence in the U.K. lending arena while Japans Toshiba picked up Westinghouse. All in all, the current merger wave, rising to levels not seen for six years, has boosted the value of deals that is currently running at $10 billion a day. The effects have underpinned benchmark equities, which are higher by 7.3 percent on the year. Ultimately, the renewed interest in UK based entities looks to spur further appreciation in the underlying currency as merger demand is likely to continue, bolstering the need for FX conversion.
Conclusion
With conditions in the UK gradually improving and merger and acquisition activity heating up, sentiment may be leaning towards a further appreciation in the British pound heading into the second half of 2006. However, with continued weakness in the retail sector and inflationary pressures just keeping pace with benchmark targets, sterling strength may not persist as the year comes to a close. . Slight downticks recently in manufacturing raised the question that recent up tick in activity may have been simply a flash in the pan, contributing to shrinking growth estimates. Subsequently, this is likely to heavily influence policy makers in reaching a rate cut decision in order to spark consumer spending as the sectors weakness is likely to continue further on in the year, If anything, consensus estimates may suggest a rate cut in the third quarter, feeding into potential spikes in spending for the year end months. However, with focus looming over the weaker U.S. dollar infrastructure and a widening trade deficit, sterling downside may be minimised leading to compressed trading ranges for much of the year.
GBP/USD Technical Outlook
2006 has been a much different story for the British Pound. While market conditions for the previous 6 years have been of either the trending or wide ranging variety, Cable has spent most of 2006 and February 6th to present, oscillating between 1.7229 (3/10 low) and 1.7624 (3/6 high). The first 5 weeks of the year saw price spend limited time outside of that range, with only the week ending on January 27 trading completely outside of the congestion. Strength for the week ending on January 27 was rejected 8 pips shy of the 61.8% fibo level of 1.8500-1.7046 at 1.7942. Although the pair pierced its 40 week moving average during that week, it closed well below the average and has failed to close a week above the SMA since May 6, 2005. Since February 6th, the pair has been contained by the aforementioned range, bound mainly by the 23.6% fibo of 1.9539-1.7046 at 1.7628 and the 76.4% of 1.7046-1.7934 at 1.7256 with just immaterial breeches of the supporting fibo level.
In projecting direction, it is interesting to note that for the week ending April 14, 2006, the slope of the 40 week moving average has changed from negative to positive. This is the first change in slope since slope changed from positive to negative during the week ended on July 1, 2005. Further, weekly oscillators (RSI, CCI, MACD) are sloping up after illustrating strong positive divergence after making new lows at the end of November 2005. Cable is currently trading within a long term bearish flag with implications from the 40 week moving average suggesting a rally to the confluence of the upper end of the flag formation / 38.2% fibo of 1.9545-1.7042 at 1.8000. Weakness targets the mentioned 76.4% of 1.7046-1.7934 at 1.7256 with a break exposing the December 2005 low at 1.7046. If bears blast their way through, then an assault on the 50% fibo of the 1.3675-1.9548 June 2001-December 2004 bull wave at 1.6610 is a possibility.
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