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The British Pound has struggled to find direction in 2011. After getting off to a solid start – rising 4% against the US dollar in less than a month -  the Pound has since stagnated. At 1.625 GBP/USD, it is now at the same level that it was at five months ago. Given the paltry state of UK fundamentals, the fact that it still has any gains to hold on to is itself something of a miracle.

The Pound’s failure to make any additional headway shouldn’t come as a surprise. First of all, the Pound is not a safe haven currency. That means that the only chance it has to rise is when risk is “on.” Unfortunately, the Pound also scores pretty low in this regard. Annual GDP growth is currently a pathetic .5%, and is projected at only 1.8% for the entire year. Inflation is high, and both the trade balance and the current account balance are in deficit. Deficit spending has caused a surge in government debt, and there is a possibility that the UK could lose its AAA credit rating.

Investors might be willing to overlook all of this if interest rates were at an attractive level. Alas, at .5%, the Bank of England’s (BOE) benchmark rate is among the lowest in the world. Moreover, it isn’t expected to begin hiking rates for many months, and even then, the pace will be slow. Simply, the economy is too fragile to support a serious tightening of monetary policy. Interest rate futures reflect a consensus expectation that rates will be only 75 basis points higher one year from now.

If that’s the case, why hasn’t the Pound crashed entirely? To be fair, the Pound is losing groroundround against both the euro and the franc, the former of which has it bested in economic grounds while the latter is cashing in on its status as a safe haven currency. On the other hand, the Pound is still up for the year against the US dollar and Japanese Yen, both of which are also safe haven currencies.

It could be the case that the Pound is simply not the ugliest currency, since all of the charges that can be leveled against it can similarly be leveled against the dollar. Head-to-head, it’s actually quite possible that the Pound still wins, if only because its interest rates are slightly higher than the US. Or, it could be the case that investors still believe the BOE will come around and begin hiking rates. After all, at the beginning of the year (when by no coincidence, the Pound was still rising), expectations were that the BOE would have already hiked twice by this time, bringing the benchmark to a level that would make the Pound attractive to carry traders. While the BOE hasn’t followed through, carry traders may be sticking around, since the opportunity cost of holding the Pound is basically nil.

As for whether the Pound correction (that I first observed last month) will continue, that depends entirely on the BOE. Unfortunately, there is very little reason to believe that the UK economy will suddenly pick up, and hence very little reason to expect the BOE to suddenly tighten. At some point, earning .5% interest on Pounds will become unattractive to investors. Until that day comes, that might stick with the Pound out of sheer inertia. While the Pound may hold its value for this reason, I don’t think it has any hope of appreciating further this year.

Last week, I was preparing to write a post about how the British pound was overvalued and due for a correction, but was sidetracked by a series of interviews (the second of which – with Caxton FX – incidentally also hinted at this notion). Alas, the markets beat me to the bunch, and the pound has since fallen more than 3% against the dollar- the sharpest decline in more than six months. Moreover, I think there is a distinct possibility that the pound will continue to fall.

Not much has changed since the last time I wrote about the pound. If anything, the fundamentals have deteriorated. Fortunately, the latest GDP data showed that the UK avoided recession in the latest quarter, but this is offset by the fact that overall GDP remains the same as six months ago and still 4% below pre-recession levels. Despite a slight kick from the royal wedding in April, the UK will almost certainly finish 2011 towards the low end of OECD countries, perhaps above only Japan. Ed Balls, shadow chancellor of the UK, has conceded, “We’ve gone from the top end of the economic growth league table to being stuck at the bottom just above Greece and Portugal.”

Of course, the question on the minds of traders is whether the Bank of England (BOE) will raise interest rates. Initially, it was presumed (by me as well) that the BOE would be the first G4 central bank to hike, if only to contain high inflation. In fact, at the March monetary policy meeting, three members (out of nine) voted to do just that. However, there stance softened at the April meeting, and they have since been beaten to the bunch by the European Central Bank (ECB) which is notoriously more hawkish.

Now, it seems reasonable to wonder whether the BOE might also fall behind the Fed. While still high (4%), the British CPI rate has slowed in recent months. “The bank’s Governor Mervyn King said on Jan. 26 that rising prices would be temporary.” Moderating commodity prices have reduced the need for a rate hike, and bolstered the case for keeping the pound week. Unemployment is high, construction spending is falling, and the current account deficit remains wide. Moreover, budget cuts (declined to contain a national debt that has almost doubled in the last three years) and a a hike in the VAT rate have dampened the economy further, to the point that it might not be able to withstand even a slight rate hike.

Furthermore, record low Gilt (the British equivalent of the US Treasury bond) rates reflect expectations for continued low rates for the immediate future. If Q2 GDP growth – which won’t be released for another 3 months -is strong, the BOE might conceivably vote to tighten. Still, we probably won’t see more than one 25 basis point before 2012.

It seems that the only thing that kept the pound afloat so long was its correlation with the euro, which recently rose above $1.50. It has since fallen dramatically and dragged the pound down with it. In fact, the pound probably needs to fall another 3% just to stay on track with the euro. If this correlation were to break down, it would almost certainly fall much further.

It has become cliched to suggest that the forex markets have become a reverse beauty pageant, whereby investors vote not on the most attractive currencies, but rather on the least ugly. At this point, it is safe to say that among G4 currencies, the pound is the ugliest.

Yesterday, UK Chancellor George Osborne announced that his government was ready to begin rebuilding its foreign exchange reserves. Depending on when, how, (or even if) this program is implemented, it could have serious implications for the Pound.

Forex reserve watchers (myself included) were excited by the updated US Treasury report on foreign holdings of US Treasury securities. As the Dollar is the world’s de-facto reserve currency and the US Treasury securities are the asset of choice, the report is basically a rough sketch of both the Dollar’s global popularity and the interventions of foreign Central Banks. Personally, I thought the biggest shocker was not that China’s Treasury holdings are $300 Billion greater than previously believed (with $3 Trillion in reserves, that’s really just a rounding error), but rather that the UK’s holdings declined by 50% in 2010, to a mere $260 Billion.

Given that the Bank of England (BoE) injected more than $500 Billion into the UK money supply in 2010, I suppose that shouldn’t have been much of a revelation. After all, selling US Treasury Securities and using the proceeds to buy British Gilts (sovereign debt) and other financial instruments would enable the BoE to achieve its objective without having to resort to wholesale money printing. In addition, if not for this sleight of hand, UK inflation would probably be even higher.

Still, this is little more than a mere accounting trick, and those funds will probably still need to be withdrawn from the money supply at some point anyway. Whether the BoE burns the proceeds or reinvests them back into foreign instruments is certainly worth pondering, but insofar as it won’t impact inflation, it is a matter of economic policy, and not monetary policy.

As Chancellor Osborn indicated, the UK will probably send these funds back abroad. In addition to providing support for the Dollar (as well as another reason not to be nervous about the upcoming end of the Fed’s QE2), this would seriously weaken the Pound, at a time  that it is already near a 30-year low on a trade-weighted basis. After falling off a cliff in 2009, the Pound recovered against the Dollar in 2010, largely due to the BoE’s shuffling of its foreign exchange reserves. To undo this would certainly risk sending the Pound back towards these depths.

On the one hand, the UK is certainly conscious of this and would act accordingly, perhaps even delaying any foreign exchange reserve accumulation until the Pound strengthens. On the other hand, the BoE is under pressure to fight inflation. It is reluctant to raise interest rates because of the impact it would have on the fragile economic recovery. The same can be said for unwinding its asset purchases. However, if it offset this with purchases of US Treasury securities and other foreign currency assets, it could weaken the Pound and maintain some form of economic stimulus. Especially since the UK has run a sizable trade/current account deficit for as long as anyone can remember, the BoE has both the flexibility/justification it needs to coax the exchange rate down a little bit.

Ultimately, we’ll need more information before we can determine how this will impact the Pound. Still, this is an indication that the GBP/USD might not have much more room to appreciate.

While I’m fondest of analyzing all currencies relative to the Dollar (after all, it’s what I’m most familiar with and is involved in almost half of all forex trades), sometimes its interesting to look at cross rates.

Take the Pound/Euro, for example, arguably one of the most important crosses, and one of a handful that often moves independently of the Dollar. If you chart the performance of this pair over the last two years, however, you can see the distinct lack of volatility. It has fluctuated around an axis of 1.15 GBP/EUR, never straying more than 5% in either direction. In fact, it’s sitting right at this level as I compose this post.

Yesterday, I read some commentary by Boris Schlossberg (whom I interviewed in 2010), Director of Currency Research at GFT. In the title (“Euro and Pound Go Their Separate Ways”), he seemed to suggest that a big move was imminent. Aside from noting that both currencies stand at crossroads, he declined to offer more concrete guidance on the direction of the potential breakout.

At the moment, the markets are gripped by risk aversion, caused by the Mid East political turmoil and the Japanese natural disasters. Once these events run their course and the accompanying market tension subsides, investors will need something else to latch on to. Perhaps the Bank of England (BoE) and European Central Bank (ECB) can fulfill this function, since both are on the verge of hiking their respective benchmark interest rates . Absent any other developments, the timing and speed of such hikes will probably dictate not only how these currencies perform against each other, but also how they perform against the Dollar.

Despite the numerous indications that both have given to the contrary, I don’t think either Central Bank is in a hurry to raise interest rates. Economic growth remains poor, unemployment is high, and inflation is still moderate. Neither is yet at the stage where it can unwind the monetary easing that it put in place at the height of the financial crisis. Moreover, both are wary about the potential impact of rate hikes on their respective currencies (a concern that I am ironically fomenting with this post).

It looks like the BoE will be the first to act. Combined with high energy prices, the bank’s easy monetary policy is putting extraordinary pressure on prices, and it now appears that inflation could reach 5% in 2011. In addition, the BoE voted 6-3 at its last meeting in favor of tightening, which means that a hike probably isn’t too far off. On the other hand, the ECB is talking tough, but it still doesn’t have much of an impetus to act. Inflation is moderate, and besides, the region’s banks remain too dependent on ECB cash for it to serious contemplate being aggressive.

Either way, the interest rate differential probably won’t be great enough to encourage any short-term speculation between the two currencies. In addition, I think investors will continue to look to the Yen and the Dollar for guidance, and we won’t see any significant movement in either direction. [The chart below is based on benchmark lending rates and isn't necessarily applicable for retail forex trading].

This would create two opportunities for investors: Options traders should consider a long straddle, which involves selling a put and call at the same strike price (perhaps 1.15), pocketing the premiums, and praying that the rate doesn’t fluctuate much (since they would be exposed to unlimited risk). In the future, carry traders can also profit from the lack of volatility through a carry trading strategy, perhaps amplified by a little leverage. Be careful, however. Since interest rate differentials are currently so small (The current LIBOR rate disparity is a mere .05%!) and probably won’t widen to more than 1% over the next twelve months, any profits from interest could easily be wiped out by even the smallest adverse exchange rate movements.

The British Pound has risen almost 15% against the Dollar over the last twelve months. It seems that the markets are ignoring the fiscal concerns that sent the Pound tumbling in 2010, and focusing more on inflation and the prospect of interest rate hikes. At this point, the Bank of England (BOE) is now racing with the European Central Bank (ECB) to be the first “G4″ Central Bank to hike rates.

You can find cause for optimism towards the Pound in technical factors alone. That’s because while dozens of currencies appreciated against the Dollar in 2010, most were starting from a stronger base. For example, the Canadian and Australian Dollars collapsed during the credit crisis. However, both currencies made speedy recoveries to the extent all losses were erased in only two years. The British Pound, in contrast, still remains 25% below its pre-credit crisis high, more depressed than perhaps any other currency.

On the one hand, this is probably justifiable. The British economy is still in abysmal shape; the latest GDP figures revealed a .6% contraction in the fourth quarter of 2010. Meanwhile, the ECB forecasts only 1.4% growth in 2011, and many analysts think that might even be too optimistic. With the exception of Japan, which suffers from a unique strain of economic malaise (not to mention the 5% hit to GDP caused by the earthquake), the UK is unequivocally the weakest economy in the industrialized world.

On the other hand, this is mostly old news. The reason that investors are starting to get excited is interest rate hikes. According to the minutes from its March meeting, the BOE voted 6-3 to hold its benchmark interest rate at .5%. That means its awfully close to acting. The market consensus is for a 25 basis point rate hike in the next three months, and 2-3 additional hikes over the rest of the year. Depending on how the other G4 Central banks act, that will put the UK rates at the top of the pack.

However, it’s unclear how extensive this tightening will be. According to one analyst, “The probability of a hike in the next three months is significant but the lingering credit crunch, fiscal tightening and bleak outlook for real incomes suggest that if this is the beginning of a tightening cycle, it will be a very shallow one.” Moreover, low bond yields suggest that long-term inflation expectations (and hence, the need for rate hikes) remain low.

At this point, it looks like the UK is looking at a few years of stagflation. That’s certainly going to be bad for UK consumers and probably negative for most UK asset prices. However, short-term currency speculators are less concerned about economic fundamentals, and more concerned about (risk-adjusted) interest rate differentials. That means that if the BOE fulfills expectations, the Pound will probably get a little short-term kick.

The last few years have been volatile for the British Pound. In 2007, it touched a 26-year high against the US Dollar, before falling to a 24-year low a little more than one year later. During the throes of the credit crisis, analysts predicted that it would drop all the way to parity. Alas, it has since managed to claw back a substantial portion of its losses, and finished 2010 close to where it started.

At the moment, however, there are two contradictory forces tugging at the Pound, which could send up upwards against the Euro but lower against the US Dollar. The first is the sovereign debt crisis in the EU, which flared up dramatically in 2010 and currently threatens to crippled the Euro. I will offer more commentary on this issue in a later post; for now, I just want to point out its role in supporting the Pound. While the Dollar is the Euro’s chief rival, many traders have turned to the Pound (and the Swiss Franc) because of their regional proximity. “As long as the euro-zone debt crisis is in the focus of the market, it will be the main driver of euro-pound,” summarized one strategist.

The second force (or set of forces) is propelling the Pound in the opposite direction. Basically, the UK economy remains depressed. Thanks to an unexpected contraction in the fourth quarter, GDP growth in 2010 was an exceptionally modest 1.7%. This was hardly enough to compensate for the average annual growth of .1%/year from 2006 to 2009, and send the Pound tumbling. Forecasts for 2011 and 2012 have since been revised downward to about 2%.

In order to spur Britain’s export sector, the Bank of England has deliberately acted to hold down the Pound, which it has managed to achieve through a combination of quantitative easing and low interest rates. “For a long time that’s what we were targeting, and we managed to get it down by about 25 percent — the exchange rate, that’s had a huge benefit to the U.K. economy,” a former member of the monetary policy committee recently admitted.

An unintended byproduct of this policy has been price inflation. At 3.75%, the inflation rate is among the highest in the industrialized world, and certainly the highest among G4 currencies. At the very least, the Bank of England will have to suspend any aspirations to match the Fed in printing more currency and expanding its QE program. It will probably also have no choice but to raise interest rates, which it might otherwise not have done until the economy is on more solid footing. The markets are currently projecting an initial rate hike of 25 basis points in the third quarter, and for the benchmark rate to exceed 1.5% by the end of the year, compared to .5% currently.

It’s difficult to say how the currency markets will make sense of this. Given that real interest rates will remain negative (due to inflation), it seems unlikely that any yield-seeking investors will suddenly start targeting the British Pound. In addition, given that the risk of ‘stagflation’ in the UK is now real and that the government is set to assume a record amount of new debt over the next few years, risk-averse investors will probably stay away. According to the latest Commitment of Traders report, speculators are already starting to establish bearish positions against the US Dollar.

While the Pound looks vulnerable, the big unknown is ultimately the EU fiscal crisis. If one of the peripheral members leaves the Euro, as some commentators predict will finally happen, then all bets (for the Pound, etc.) are off.

The rally in the Pound, which lifted it 10% from trough to peak, appears to be fizzling. The Pound is already down 3% in the last two weeks, and is trending downward. It now stands at a four-week low against the Dollar.

Looking back at the Pound’s two-month rise, it’s not hard to understand why it was unsustainable. You can see from the charts below that there was a strong correlation with the Euro and the S&P 500 over the same period of time. This suggests that the Pound rally was less a product of changing fundamentals and more due to a sudden decrease in risk aversion.

By no coincidence the rally in equities, the Euro, and a handful of other proxy vehicles for risk, all came to and end at the same time as the Pound. In a nutshell, the markets are back to focusing on fundamentals. Namely, the risk of a double-dip recession, combined with a lack of resolution in the Eurozone debt crisis is causing investors to think twice about making bets that entail any kind of risk.

In this regard, the Pound is especially vulnerable. On the economic front, the UK economy only grew by 1.1% in the second quarter, with economists predicting only modest growth for the year. According to an economist for the Bank of England, “It would be ‘foolish’ to rule out a renewed downturn.” Evidently, his bosses agree: “The Bank of England last week said growth will be weaker than it forecast in May, citing “continuing fiscal consolidation and the persistence of tight credit conditions.”According to a recent poll, almost half of British households are pessimistic about the country’s economic prospects in the near-term: “The proportion of pessimists is marginally lower than in July, but is higher than in any other month since March last year.”

Ironically, the efforts of the British government to curb spending and cut the deficit are perceived as making matters worse. Since these measures won’t be offset by lowered taxes, they will directly lead to lower economic growth. Given that both the Pound and UK bond prices are rising (implying an increased risk of default), I think this reinforces the point I made last week about the markets not caring at all in this economic climate about increasing national debt.

The icing on the cake is inflation. A British think-tank