By Pinchas Cohen
Pound Boosted By Rhetoric
The British pound surged 3 percent last week. On Thursday, Bank of England's meeting minutes revealed policy makers were ready to raise interest rates for the first time in over a decade. On Friday, policymaker Gertjan Vlieghe said: “The evolution of the data is increasingly suggesting that we are approaching the moment when bank rate may need to rise.” What was so exceptionally bullish about Vlieghe’s statement is that just in July he told The Independent that a rate rise would be “premature” and a “mistake.” No hawk can compete with a dove’s hawkishness.
Cable jumped to its highest level in 15 months, performing its best weekly gain since February 2009 and the fourth best weekly performance in 40 years.
Wages Don’t Support Inflation
UniCredit says that raising the rate this year or early next year would be a “policy mistake” considering wage growth is not supporting inflation, in which consumers fall behind growth. Economists’ focus has been on inflation to rise, as an expression of economic growth. When prices rise, businesses make more money, allowing them to expand, which creates jobs. The rising demand for employees causes a lower available supply of workforce, creating pressure for rising wages.
Higher wages allow for more consumer spending, which creates a higher demand on a relatively lower supply of goods. This causes prices to rise, and the cycle starts again. This upward spiral, or “virtuous cycle,” to adopt Mario Draghi’s term in his introductory speech at the ECB Forum on Central Banking at Sintra, Portugal, on June 27, causes the wealth creation to spread, as everyone’s making more money.
If, however, wage growth doesn’t rise along with inflation, consumers’ purchasing power diminishes. There is a decrease in demand of goods artificially priced higher. The falling demand will cause prices to fall, creating a negative downward spiral, or a vicious cycle, causing wealth destruction to spread, as everyone’s making less money. UniCredit is concerned of such a scenario in the UK.
Brexit Uncertainty
If it's not enough to be long-term bearish on the pound on the absence of wage growth, the biggest economic uncertainty in decades, caused by Brexit, still looms. The currency lost 23 percent of value in a little over three months. Since then, it has pared an impressive 13 percent, but the uncertainty has not dissipated and nothing has changed. That suggests that should the UK fail to overcome this giant hurdle, there is a downside risk to a retesting of the $1.1450, October flash-crash trough.
Sterling Helped By Dollar Weakness
Finally, of the almost 13 percent rise in the pound since late January, the dollar fell more than 9 percent. Much of sterling’s advance was not on merit of its strength but on dollar weakness. If you measure sterling against a basket of currencies you learn it has depreciated 10 percent. Some maintain that the dollar may stabilize, after receiving a boost from rebuilding in the hurricane aftermath. Either way, one economy’s potential weakness does not render another weak economy a sound investment. Let’s also remember the importance of exchange between the UK and Europe. Europe is the UK's biggest trading partner, accounting for 78 percent of the latter's trade.
The currency gains and losses against the euro are like that of the dollar. During the same period, it first lost 24 percent and has since pared losses to 15.7 percent. However, more than half of that paring was done last week on data and rhetoric this post contests. Either way, while the dollar is still within a clear downtrend and a stalling economy, the euro is in a clear uptrend with an economy that is leading global growth. Therefore, the pound's gain on dollar softness is unsustainable.
While the pair has been up-trending since the October flash-crash, the vertical surge of the last two weeks have hit a brick wall, when they reached the long-term downtrend line since July 2014. The longer a trendline and the more time it’s been tested the more reliable it is. Imagine a Fiat 500 running into a Humvee.
Trading Strategies
Conservative traders would wait on a short for a confirmation that the long-term trend remains intact, when the midterm uptrend line since October would be violated to the downside. That would likely happen below 1.3000, with a stop-loss above that key level.
Midterm traders might be satisfied with a confirmation of a close beneath the 1.3500 psychological round number, with a stop-loss above that key level.
Aggressive traders may be satisfied with a confirmation of another week’s close beneath the long-term downtrend line, with a stop-loss above the downtrend line.
Very aggressive traders would short immediately, with a stop-loss above the down-trend line, or at least above last week’s 1.3617 high.
Price Targets
The first target would be when the price retests the uptrend line since October, which may be at around 1.3000–1.3200. The second target would be the 1.2000, January 2017 trough. The final target would be the 1.1450, flash-crash low.
Remember not to enter trades that don’t afford at least a 1:3 risk-reward ratio.
After the 1:3 risk-reward ratio has been satisfied, especially after another support has been broken, per the price levels described in the Trading Strategies section, a trader may move his stop-loss above the next support, to protect his gains. In this way, traders open the potential to increase the profits multiple times over on the same original risk.