Fundamental Forecast for British Pound: Neutral

The British pound struggled to maintain the rebound from the May low (1.6353) on Friday, and the sterling is certainly at risk of facing additional selling pressures in the following week as currency traders turn their attention to the Bank of England’s quarterly inflation report, which is likely to highlight the dovish tone held by the majority of the Monetary Policy Committee. As the MPC holds the benchmark interest rate at 0.50% while maintain its asset purchase target at GBP 200B this month, we are likely to see the committee continue to carry out its current policy heading into the second-half of the year.

With the inflation report due out ahead of the BoE minutes on May 18, Governor Mervyn King may talk down speculation for higher borrowing costs during the press conference as the economic recovery in the U.K. cools. As the recent batch of economic developments from the isle-nation confirms a slower pace of growth in manufacturing and service-based activity, we should see the central bank continue to point out the ongoing weakness within the private sector. At the same time, Mr. King may explicitly show an increased willingness to preserve the unprecedented expansion in monetary policy for most of 2011 as he expects the substantial margin of slack within the real economy to bear down on price growth. However, as Standard and Poor’s expects to see heightening price pressures in the U.K. and project a BoE rate hike in the next three-months, the central bank may soften its dovish outlook for monetary policy. An upward revision in the inflation forecast should help the GBP/USD to regain its footing, and the exchange rate may consolidate over the near-term as investors weigh the prospects for future policy.

Nevertheless, the central bank may curb its outlook for growth and inflation in order to defend its wait-and-see approach, and the GBP/USD may continue to retrace the advance carried over from the previous month as interest rate expectations falter. According to Credit Suisse overnight index swaps investors now see borrowing costs in the U.K. increasingly by 25bp over the next 12-monts amid projections for 50bp worth of rate hikes in April, and the GBP/USD may threaten the upward trend from earlier this year should the BoE adopt a highly dovish tone in its quarterly inflation report. As a result, the near-term correction in the GBP/USD may gather pace over the following week, and the exchange rate may test the 23.6% Fibonacci retracement from the 2009 low to high around 1.6200-20 should price action fall back below the 50-day moving average at 1.6284.

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