Sterling Looks Set For Multi-Year Lows
$FXB, $GBB
Emerging market currency rout is likely to accelerate "import" deflation.
Falling commodity prices will only compound the deflationary environment.
Increased deflationary pressures will delay rate hikes from the BoE.
BoE likely to be one of the first to conduct balance sheet expansion should deflationary pressures continue.
As part of our broader view of a global slowdown developing in the second half of 2015 and into 2016 due to weakness in Emerging Markets, we see potential for a severe correction in sterling developing in the months ahead. Coming off the mid-April lows, the pound has been trading in a tight range of 1.5150-1.5650, proving to be one of the more resilient currencies against the US dollar year to date. Given the turbulent economic picture globally, we see considerable risks to sterling going forward, and would be looking to short the pound with a 6 to 9 month price target of 1.40 to 1.35, which would result in new multi-year lows.
Emerging market currency rout is likely to accelerate "import" deflation
The ongoing rout in commodity prices and emerging market currencies is likely to accelerate "import" deflation within the United Kingdom, a trend we should start seeing to develop in the ONS inflation figures going into the second half of 2015. Sterling has strengthened considerably against some of its key trading partners throughout July, most notably against the South Korean won in the emerging world and the euro in more developed circles. Sterling has gained 10% against the won this year alone, 12% against the euro and a staggering 21% against the Aussie dollar. It will be the rapid deterioration against key export currencies like the won however that will have the BoE most concerned. Perhaps even more ominous is the fact that sterling is still actually weaker by 2% against the yuan in 2015 despite the recent devaluations, highlighting just how much further China could devalue the yuan to regain a competitive footing with its export dependent neighbors. Any severe appreciation against the yuan going forward is sure to provoke some sort of retaliatory response from the BoE.
Falling commodity prices only compound the deflationary environment
The UK has already been contending with deflationary pressures since the -0.1 percent decline recorded in May - the first official deflation reading in over 50 years. Subsequent CPI readings in June, July and August have been anemic at best. An appreciating currency will only add to these pressures, especially given the broad fall in commodity prices over the same period. Despite sterling weakening nearly 6% against the dollar year to date, the fall in inflation-related commodities such as crude oil has been much sharper, hovering near a 6-year low and producing a net deflationary effect for the UK. Again this trend is likely to cement itself going forward into 2015 and will be one of the key driving force behind our short GBP/USD thesis.
Increased deflationary pressures will delay rate hikes from the BoE
We believe the market will continue to abandon the notion that the BoE will raise rates once the extent of the deflationary threat confronting global markets is fully digested. Rate hike expectations have been one of the key pillars of support for sterling in 2015, setting up the stage for a significant reversal in the pound should these expectations begin to fade.
Since the deflationary print in May, the mild sell-off in sterling already suggests a portion of the market is leaning in this direction.
BoE likely to be one of the first to conduct balance sheet expansion should deflationary pressures continue
Looking through the next 6 to 9 months, one of the biggest events we see on the horizon is a return in some shape or form of significant balance sheet expansion or increased jawboning/direct currency intervention by one or more of the developed world's central banks,. The growing threat of deflation worldwide is likely to spark at least one major player into action, and we would not be surprised if the BoE came to the forefront in this regard.
Summary
We are calling for a drop in GBP/USD, with our first target to breakthrough multi-year lows to 1.40 before settling at 1.35 in the next six to nine months. We see a deteriorating deflation picture in the UK, revised rate hike expectations, combined with risk-off sentiment in global financial markets to be the key driving forces behind the move.
Our data now shows a remarkable 70 percent of open GBP/USD positions in our sample are long; a contrarian view leaves us firmly bearish. The only caveat is straightforward—retail positions are often at their most one-sided at major market turns. And indeed, our Speculative Sentiment Index shows the largest ‘crowd’ long position since the GBP/USD reversed higher off of $1.41 mark just one month ago.
Such extremes are only clear in hindsight, however; until we see concrete signs of a sentiment shift we will remain in favor of selling into GBP/USD weakness.
--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com
Contact David via
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