Fundamental Forecast for the British Pound: Neutral

The short week between the Christmas and New Years holidays – a period of understandably low liquidity that is notoriously fraught with spikes of knee-jerk volatility amid otherwise stand-still calm – seems hardly the time to be searching for trade ideas. Indeed, traders would be wise to exercise extreme caution, both with initiating new positions and managing existing ones. With that said, it is still worth to review the underlying drivers shaping currencies’ trajectories even if their response to these forces is not ideal over the near term, as it will be within the context of these themes that any trade decisions ought to be considered when price action cannot be taken as a reliable measure of the markets’ true sentiments.

For the British pound, these underlying forces seem to point toward a well-supported position relative to most of its major counterparts. The correlation between GBP/USD and overall risk sentiment (as tracked by the MSCI World Stock Index) as weakened considerably over the past two weeks as resurgent rate hike expectations shifted the focus back to monetary policy. Indeed, a Credit Suisse gauge of traders’ priced-in rate hike outlook stands near the highest levels in 8 months. Meanwhile, the Euro Zone debt crisis continues to fester. Last week’s run-up in periphery credit-default swap (CDS) spreads – the price of insuring against a sovereign default – suggests the markets are hardly encouraged by policymakers’ attempts to squash the matter, with the threat of continued contagion poised to grow in 2011. On balance, this seems likely to feed demand for Sterling as an alternative European unit of exchange amid a loss of confidence in the single currency.

Structurally, the pound also seems relatively well-positioned. The UK currency is the least overvalued against the US dollar when compared to "fair" exchange rates implied by Purchasing Power Parity. Furthermore, it has lagged the other majors against the greenback in the second half of the year while the maligned euro has done considerably better, hinting that some catch-up may be in order. While all of this surely does not guarantee that Sterling is necessarily heading higher over the near term, the foundations for an advance certainly appear to be present.

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