Does the Pound Still Have Upside Potential?

When the Conservatives took back the government in May after years of Labour rule, the Keynesian lefties warned that the Conservatives' austerity plan would lead to disaster. Writing in the NYT on October 27, 2010, Paul Krugman said:

"The British government’s plan is bold, say the pundits — and so it is. But it boldly goes in exactly the wrong direction. It would cut government employment by 490,000 workers — the equivalent of almost 3 million layoffs in the United States — at a time when the private sector is in no position to provide alternative employment. It would slash spending at a time when private demand isn’t at all ready to take up the slack.

What happens now? Maybe Britain will get lucky, and something will come along to rescue the economy. But the best guess is that Britain in 2011 will look like Britain in 1931, or the United States in 1937, or Japan in 1997. "

This austerity plan, calling for a modest increase in taxes, and a gradual reduction in the size and cost of the government seems to be working, and without infliction of the draconian pain feared by opponents. Most of the Brits fundamental numbers seem to portray an economy that is muddling through.

The pound has appreciated a long way since the election of PM Cameron where it was 1.43 when he was elected in May. The gradual economic changes being implemented seem to be working. Recently the pound has also benefited from an inflation rate higher than the target of the Bank of England. This has made for some lively discussion about a potential rate hike. This attitude has served to bolster the yield on two year gilts to 1.37%, a hearty premium to the weak .70% US yield.

The pound does have a legitimate bull story, but there is a reason to be wary. In late December when the pound was making a swing low a little under the 1.54 handle, the open interest in the CME futures was as low as 70k contracts, far less than the 128k contracts open today. Also, according to the 12 28 2010 COT report, specs were short 17,828 contracts. In the latest report dated 02 22 2011, specs are now long 45,888 contracts. This means specs have been big net buyers of the pound, over 63k contracts since late December.

Bull markets need bull news and fresh money coming into a market to sustain the trend, and the pound versus the USD might be a little overextended. Before getting bearish on the pound, however, the same group that was mocking the intelligence and approach of the new conservative British government has the ear of the administration in Washington.

Should a state governor attempt to balance a budget, he will incur the wrath and ridicule of the NYT, the major TV networks, and the administration.

Another problem for the USD is Fed Chairman's 'Mission Impossible' mandate. This audacious misguided decision to use monetary policy to reduce unemployment seems obtuse, and not helpful to strengthening the USD.

The bottom line here is that though the pound may be too long, and perhaps over bought, it is best to look for a spot to be a buyer of the pound versus the USD. The 1.6220 level looks interesting but in addition to the US NFP, and employment numbers, there is also the Halifax HPI coming out in the morning. For those a little more cautious, the 1.6150 might be a better place to try the long side.

Attached Image