British Pound Sterling is Crashing as U.K. Political Risks Rise

Witawat (Ed) Wijaranakula, Ph.D.
Mon Mar 21, 2016

The GBP/USD currency pair inched 0.79% lower to close at 1.4366 dollars per pound on Monday, following the late Friday resignation of Work and Pensions Secretary Iain Duncan Smith who cited the “deeply unfair” government tax and welfare changes as his reason for quitting. According to CNBC, the reason for Duncan Smith’s resignation could be solely about the U.K. referendum vote on whether to remain in the European Union on June 23. Some political commentators suggested that Duncan Smith, one of a number of senior Conservatives supporting the “Leave” campaign, is using the budget to cause a damaging split in the party.

U.K. Prime Minister David Cameron announced the referendum, to be held on June 23, on whether Britain should exit, or stay in, the EU. The referendum has been a hot-button issue after the Conservative Party won a majority of seats in the House of Commons in the May 2015 general election, as David Cameron reiterated his party's manifesto commitment to hold a referendum on whether Britain should remain in the European Union by the end of 2017. On Monday, The Confederation of British Industry warned that a U.K. exit from the EU would cause a "serious economic shock", potentially costing the country £100 billion and nearly one million jobs.

Since September 2015, the British pound sterling has been struggling against the U.S. dollar as downside risks for U.K. economic growth has increased from the slowing Chinese economy, as well as from other emerging countries. Britain’s overall trade deficit in goods and services has widened, while U.K. factory output fell. The Office for National Statistics (ONS) said in early March that the U.K. trade deficit narrowed in January, but its goods trade gap with the EU widened to a record level, according to the BBC.

The British pound sterling got some support during the past several weeks, as most currency traders were speculating that the Fed would push a second rate hike out to July or later. As expected, the U.S. Federal Reserve kept the rate unchanged at between 0.25% and 0.5% at its March FOMC meeting, and hinted that they may make only two rate increases by the end of the year, half the number that was forecasted at its December meeting. The Fed trimmed its economic growth outlook for the year to 2.2%, from the previous forecast of 2.4% growth, and its forecast for inflation to 1.2% from 1.6%. 

The Bank of England (BOE) might have followed the Fed’s move, as last week, all nine members of the Bank's Monetary Policy Committee (MPC) voted to keep rates at the record low 0.5%, for the seventh year. Late last year, BOE Governor Mark Carney told the members of parliament on the Treasury Committee that U.K. interest rates are likely to remain low "for some time". Mr. Carney, however, reiterated his long-term view at that time that the Bank's next move might actually be a rate hike.

As of March 15, there are 104,520 short positions of British pound sterling, traded on the Chicago Mercantile Exchange (CME), by leveraged funds, a week-over-week decrease of 10,117 short positions. This is compared to about 78,410 long positions, up 38,693 from the previous week, according to the Commitment of Traders (COT) data released by the Commodity Futures Trading Commission (CFTC). Hedge funds have increased their net long positions about 48,810 contracts from the previous week in response to the Fed’s dovish move, where British pound sterling contracts are traded in units of 62,500 GBP. 

From our technical viewpoint, the GBP/USD just broke out the descending wedge chart pattern, but the uptrend might not be sustainable as the long-term sentiment for the British pound sterling is bearish, while the referendum and U.K. politics continue to be a dark cloud throughout the first-half of 2016. 

A mixed bag of U.S. economic data could force the Fed to stay on the sidelines until its September 20-21 meeting, though. The federal funds futures, traded on the Chicago Mercantile Exchange and commonly used to estimate the market’s views on the likelihood of changes in U.S. monetary policy, now stands at 38% odds for a rate hike at the Fed’s FOMC meeting on June 14-15, while the odds are only 47% for the July 26-27 meeting, according to data from the CME Group as of March 22. Hence, the GBP/USD could be trading in a narrow range between 1.38 and 1.46 dollars per pound until the political uncertainties dissipate.


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