Weekly Fundamental Analysis: Sterling Downside May Be Overdone

By: Kevin Sollitt

Although the UK’s coalition Government is over a month into its term, political undercurrents are having an overbearingly negative influence on financial markets as far as the current valuation of Sterling is concerned; maybe markets are just coming to terms with the new order of things as the outlook remains somewhat clouded.

Cable peaked at around 1.64 earlier in 2010 apparently due to three main factors: political uncertainty, deterioration in the UK’s fiscal position and the heightened fear of investors expecting contagion by the Eurozone which accounts for around 50% of UK exports.

While we acknowledge the negativity primarily generated by fiscal concerns, it should be noted that Cameron & co have already taken immediate steps to address the uphill battle they face by announcing 6 billion GBP of cuts soon after taking office. On June 22^nd, an emergency budget is expected to further improve the fiscal position, although a fine balancing act may be required between making the necessary cuts yet prevent the country from tipping back into recession if using overly excessive measures.

The third factor is also somewhat under control evidenced by the Eurozone’s collaborative approach to their widespread financial issues, which at one point looked very close to threatening the very existence of the Euro. Not to say this danger has completely passed, but with official Greek comments last week indicating that failure is not an option and the financial assistance provided by international partners, a sense of stability has returned to the EUR, at least for now.

Markets always overshoot and Sterling in the low 1.40s is approximately 12-15% below its ten-year average value against the USD. Some of the best opportunities in FX often present themselves when markets become obsessed with one side of a cross, as seems to be the case with each side of the GBP/USD cross, another reason we like this trade.

One of our ‘golden rules’ of FX (If the reason for placing a trade becomes invalid, exit the position) is close to being breached by the market should the current obsession with selling Sterling/buying USD at any level continue, in the face of improving UK fundamentals and acknowledgement of difficult US fundamentals:

During the past two weeks we have been reminded that the USD may, in simple terms, be the best of a bad bunch as far as currencies with high unemployment, low interest rates, slowing consumer spending & deteriorating fiscal positions & could therefore be occupying an undeservedly lofty position.

In testimony to congress this week, Mr. Bernanke told us that the headwinds facing the US recovery are still strong with close to double-digit unemployment; hardly the best of reasons to continue buying USD at any price.

That said we all have to respect market momentum and we think the current situation suggests opportunity is approaching. If history is anything to go by, GBP/USD has a habit of spiking higher after bear runs in 10-cent clips, see any monthly chart for verification.

Our current view is that GBP/USD may quickly undergo a reversal in sentiment leading to reclamation of the 1.53 level (approx 50% of down move) which if sustained may see a larger recovery to the low 1.60s back towards its longer-term average.

We would reiterate the potential unwinding of long $ positions as a contributing factor as markets reassess their record short positions in GBP & EUR and also the fact that coalition or not, the UK has one government steering its policy & not 16 like the Eurozone, which should be enough to distinguish it in a positive light from an investor perspective and perhaps generate some capital inflow or reserve asset diversification.

Suggested tactics: enter 50% of position at current market 1.4550; add remaining 25% each at 1.4420 and 1.4310, stop-loss on a confirmed break below 1.4200. Raise stop to breakeven as the market rises with an initial objective of 1.50-1.53.

Good luck trading.