The economic data out of the UK is getting worse, the Bank of England is firmly on hold yet GBPUSD is hitting 4 month highs. Can the prospects for the UK really be that much better than the US?

This contradiction is being reflected in the bond markets. Although the spread between UK and US 2 year bond yields has narrowed in recent days, GBPUSD has continued to break higher.

The 2-year government bond spread between the UK and US tends to follow GBPUSD closely (as you can see in the chart below), if this relationship is to persist either the spread would have to play catch up with GBPUSD or GBPUSD would have to fall back towards the 1.6200 zone.

So what is driving GBP strength?

Mostly it's a weak dollar. The greenback is being sold across the board this week, which is boosting sterling and the euro even though the fundamentals of both currencies are fairly weak.

However, the UK is being treated a bit like a safe haven at the moment. It still has its triple A credit rating, the US lost its rating earlier this month. This has seen a sharp inflow into UK Gilts, pushing yields lower but helping to support sterling as some investors reduce their exposure to Treasuries and choose to invest in UK Gilts instead. This may well help to support the pound versus the dollar. So the pound may be the best out of a bad bunch at the moment.

GBPUSD (yellow line) and UK-US 2-year bond spread (white line)

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The future outlook for the pound:

There are a few worrying signs that suggest the pound may not be able to stay at these elevated highs versus the dollar in the medium term.

  •  According to the latest CFTC data, pound longs versus the dollar have been shrinking. Last week there were 245,000 new long speculative positions, the week before there were 5,139,000 new long positions. Partly this reflects higher levels of volatility two weeks ago, but it is worth tracking this data since if it continues it would suggest that speculative traders are losing interest in sterling.
  •  The deterioration in economic data: weak Q2 growth, weak PMI's and now weak retail sales for July suggest that further QE could be around the corner. If growth continues to deteriorate we believe the BOE will step in to plug growth gaps especially since the government remains committed to pushing through fiscal austerity. This would be pound negative.

However, as mentioned above the pound's future trajectory will depend on the outcome for the dollar, so we think GBPUSD may be stuck in a range for some time.

Some levels to note. Above the 1.6495 pivot this suggests that the momentum for this pair is higher. Above there, 1.6640 is in view ahead of 1.6740 - the high reached in May 2011.

On the downside: 1.6395 should act as good support then 1.6250.

GBPUSD daily chart

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Please note that some of these charts are from Bloomberg and do not represent prices offered by forex.com

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Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

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