The GBP/USD has at least 200-300 points of room to rally before it reaches a key technical resistance level and fundamentally, the market expects the Bank of England to raise interest rates this Thursday to 5.75 percent. The minutes from the most recent monetary policy meeting held in June revealed that 4 out of the 9 members wanted to deliver a back to back interest rate hike. With oil prices hovering near $70 a barrel, the world’s concern for inflationary pressures will not be going away anytime soon. Whether or not the BoE signals that we will see 6 percent rates this year will be the key in determining if 200-300 points of further strength will mark the top in the GBP/USD.

Inflation Risks will Force the Bank of England to Raise Rates

Economic data supports the Bank of England’s aggressive monetary policy stance. Although CPI growth has slowed to 2.5 percent from 3.1 percent just a few months ago, the figure is still well above the central bank’s 2.0 percent target. Furthermore, upside inflation risks remain as house prices continue to surge and tight labor market conditions threaten to push wages higher. Recently, the typically dovish policy maker Kate Barker said that the Bank of England risks losing credibility if it fails to contain inflation now. The central bank needs to take inflation seriously because for the first time ever, they were forced to write an open letter to the then-Chancellor of the Exchequer Gordon Brown explaining why inflation has surged beyond 1 percent of their target rate. With their integrity on the line, there is little doubt that 5.75 percent is in the cards this week. In fact, the interest rate curve is already pricing in a strong chance of 6 percent rates by year end.



GBP/USD Wave 5 Not Done Yet

The GBP/USD has broken above its 15-year high of 2.0130 which satisfies the minimum upside expectations for wave 5. The 5th wave of the entire rally from 1.7046 is unfolding as an ending diagonal (from 1.8515). The upper resistance line for the diagonal is at 2.0283 today. A small 5 wave decline (after a break above 2.0131) will signal that it is time to get bearish.



Taking Cue from the Euro

To some, the GBP/USD may look like it wants to form a double top because oftentimes traders will get nervous at key psychological levels and wonder whether the currency pair can hold above those levels. A look at the EUR/USD’s past price performance could provide some clues. The last time the EUR/USD rallied above 1.30 from much lower levels was in Nov 2006 and Nov 2004. Both times, a breach of 1.30 led to much stronger gains with virtually little retracement in the days immediately afterwards. Therefore a break of the prior 2.0133 high could still be positive for the currency in the medium term.



The Only Risk is if the Bank of England Moves to Neutral

The only caveat would be if the Bank of England decided that 5.75 percent rates was enough and moved to neutral bias after the rate hike that is expected this week. This would not be completely out of the question since the Bank of England is notorious for keeping the FX markets guessing. Rate expectations have shifted dramatically in the first half of the year as the central bank moved from neutral to hawkish and there is no reason why this cannot change again. A drop in rate hike expectations could single handedly trigger a top in the GBP/USD.

Kathy Lien is the Chief Currency Strategist at FXCM.