Fundamental Outlook for British Pound: Bearish

- Bank of England keeps rates unchanged at 0.25% and quantitative easing bill at 125 billion pounds
- Consumer confidence, manufacturing activity and mortgage approvals hit their highest levels this year
- Is GBPUSD’s plunge a temporary reversal or trend revival? Get the technical read on price action.

Up until the second half of this past week, the British pound was enjoying a steady and aggressive rally against its US counterpart. However, a 22 percent rally in as few as three months with fundamentals like the United Kingdom’s is clearly a reason to be skeptical. The nearly 700-point drop over the final three days of the trading week is far from confirmation of a trend reversal; but it should be enough of a jolt to remind market participants that Europe’s largest economy is pacing the global recession and financial conditions are balanced on a knife’s edge. Looking ahead to next week, there is likely to be short-term volatility from scheduled economic releases and a close eye kept on the stability of the government’s upper echelons; but sterling traders’ real guide will be risk appetite.

How is it that the currency of an economy that is expected to suffer the worst economic contraction in the industrialized world, has ongoing troubles with credit and financial conditions, and is now seeing political turmoil has been able to produce such an impressive rally across the board? There is the argument that the currency was oversold and that the fundamental outlook for the UK has perhaps reached an equilibrium with its major counterparts. However, this is a fundamental consideration that would take considerable time to develop. The only way a currency as fundamentally depressed as the sterling would be able to appreciate so rapidly is through a sharp turn in global growth and financial condition forecasts. The appetite for capital appreciation is fulfilled through speculation that the currency was oversold. Fundamental forecasts improve as the aggressive steps policy officials took to revive the economy would help leverage the ensuing recovery. And, yield forecasts are massaged as the MPC would be expected to reign in their quantitative easing and immediately concentrate on inflation. Is it reasonable to project such an aggressive turn in sentiment and the particular influence it should have on the pound? We seen signs around the global that the pace of recession is letting up; but that is not the same thing as a return to positive growth. To maintain a rally an advance in risk appetite, we need irrefutable evidence of a near-term economic recovery. Otherwise, speculative capital is merely building a bubble that prevailing levels of risk and return cannot support

Closer to home, sterling traders will have to concern themselves with key data releases and politics. The latter subject has hit a fever pitch over the past few weeks. While the public has long held the government responsible for the economy’s current economic woes (or at least its severity), the tumult has not reached the level where resignation has been considered – until now. Local elections have shown an irrefutable lack of confidence in sitting members and Prime Minister Gordon Brown has been forced to shuffle his cabinet. However, market participants are concerned primarily with the major players in the economic crisis - the PM himself and Chancellor of the Exchequer - whose absence could derail the progress that has been made to this point. To gauge the market’s sensitivity to such a possibility, we merely need to see the sharp drop in the pound when rumor (which had to be officially dismissed by the government) that Brown would soon announce his resignation. As for data, the docket is thin but potent. Consumer spending will be measured through the BRC’s retail sales for May. Though expectations are low. For factory activity, the plunge in industrial production has eased significantly through first quarter; but we are still waiting on the first positive reading in 14 months. Housing price indicators and trade figures will round out the picture with indirect appraisals of credit availability and foreign demand.

Antonio Sousa is a Currency Analyst for FXCM.