The British pound may face increased volatility

The British pound may face increased volatility over the next 24 hours of trading as market participants anticipate the Bank of England to hold borrowing costs at the record-low and maintain its GBP 175B asset purchase program, and the central bank may continue to hold a neutral policy stance going into the following year as the expansion in monetary and fiscal policy works its way through the real economy. The final 2Q GDP reading reinforced an improved outlook for the nation as the economy contracted at a slower pace than initial expected, with private-sector spending crossing the wires stronger than projected, and the extraordinary efforts taken on by the government should help to stem the downside risks for growth and inflation as the International Monetary Fund raises its economic forecasts and expects the growth rate to rise 0.9% in 2010. Moreover, the Nationwide consumer sentiment survey jumped to its highest level since April 2008 as the index increased to 71 in September, while mortgage approvals rose to 52.3K in August to mark the ninth consecutive monthly advance, and the government anticipate economic activity to pick up throughout the second-half of the year following the rebound in economic confidence. At the same time, consumer prices increased 0.4% during the same period, with the core rate of inflation holding at 1.8% for the second month, and policy makers are likely to hold an enhanced outlook for the economy as the MPC projects price growth to be “higher in the short-term” than the board had initially anticipated. However, the National Institute of Economic and Social Research turned increasingly pessimistic towards the economy and expects GDP to hold flat during the three-month through September as businesses continue to scale back on production and employment, while Governor Mervyn King maintained a weakened outlook for the economy and saw a risk for a slower recovery as the banking system remains fragile. As a result, the central bank may look to expand monetary policy further over the coming months to foster a sustainable recovery as households face a weakening labor market paired with tightening credit conditions. Nevertheless, Deputy Governor Charles Bean argued that downward wages pressures have helped to limit the drop in employment, and stated that the “rate of job losses might be starting to ease off” as policy makers anticipate economic activity to pick up going into the following year, and the enhanced outlook for the labor market paired with the rebound in household sentiment should continue to support the stabilization in the housing market as home affordability in the U.K. improve. As a result, the BoE is likely to remain on watch over the coming months as the central bank attempts to avoid a double-dip recession while maintaining its mandate to ensure price stability.
Trading the given event risk may not be as clear cut as some of our previous trades as the BOE retains a cautious outlook for the economy but nevertheless, long-term expectations for higher interest rates could drive the exchange rate higher as economic activity improves. Therefore, if the central bank maintains its current policy and holds an enhanced outlook for growth and inflation, we will look for a green, five-minute candle following the release to confirm a buy entry on two-lots of GBP/USD. Once these conditions are met, we will place our initial stop at the nearby swing low, or a reasonable distance taking volatility into account, and this risk will determine our first target. Our second objective will be based on discretion, and we will move the stop on the second lot to breakeven once the first trade reaches its target in order to lock-in our profits.
In contrast, fears of a slower recovery paired with the weakness in the banking system may lead the central bank to take further steps to shore up the ailing economy, and price action following an unexpected expansion in monetary policy could set the stage for a short GBP/USD trade. As a result, if the BoE increases its asset purchase program to GBP 200B, we will favor a bearish outlook for Cable, and will follow the same strategy for a short pound-dollar trade as the long position mentioned above, just in reverse.