British Pound Posts Strong Gain on Government Creation

The GBP USD advanced after it was reported that an agreementto create a new government had been reached. Traders celebrated the news thatthe Conservative party and the Liberal Democrats had formed a coalition tocreate a majority in the Parliament. 

The GBP USD advanced after it was reported that an agreementto create a new government had been reached. Traders celebrated the news thatthe Conservative party and the Liberal Democrats had formed a coalition tocreate a majority in the Parliament. The move by both parties helped put an endto the long-standing rule of Prime Minister Gordon Brown and the Labour Party.

The formation of a new government is seen as a positive forthe British Pound at this time because it provides clarity to an almost diresituation. For weeks the Sterlinghas succumbed to selling pressure due to the possibility of a hung parliament.This situation would have created a problem because it would have made itvirtually impossible for the new government to enact the austere fiscalmeasures needed to balance the budget and reduce the country’s debt.

The clarity provided by the “new coalition” between theConservatives and the Liberal Democrats comes at an important time because ofthe events taking place in the Euro Zone. The formation of a new government willhelp to provide the psychological boost the British Pound needs to reverse thecurrent down trend.

Technically, the GBP USD rallied after successfully testinga minor retracement zone at 1.4765 to 1.4695. The subsequent bottoming actionand upside reversal helped form a secondary higher bottom which attracted freshbuyers. Based on the main range of 1.5523 to 1.4474, traders should look for ashort-covering rally to the first 50% retracement level at 1.4998. Upsidemomentum through this level could drive this market into the next retracementpoint at 1.5122.

Despite the strength in the British Pound and the majorcommodity linked currencies, the U.S. Dollar Index managed to post a modestgain on Monday. Most of this was due to how the trade weighted index isformulated. The index would have finished even higher had the Dollar/Yen beenable to hold on to its earlier gains.

After a one day reprieve following the announcement of theEuropean Union’s $1 trillion bailout package, the Euro once again traded weakerthroughout the trading session. The current downside momentum suggests that themarket has the power to take out the recent bottom at 1.2518.

The historic announcement by the EU over the week-end failedto generate enough investor confidence to support the Euro, but moreimportantly reaffirmed that the destiny of the Euro is clearly in the hands ofthe hedge funds and large traders.

The fact that the Euro traded sharply lower ahead of the New York session was astrong sign that the euphoria of the past 24-hours was over and that realityhad returned to the Forex markets. Simply stated, Monday’s trading actiondemonstrated that traders accepted the fact that the EU’s aid package was ashort-term fix, but that over the long-term, the economic problems in the EuroZone would continue to exist long after the new money was sucked into thefinancial system. The post-bailout package sell-off in the Euro also served asproof that the market doesn’t believe that a country solves a debt crisis byissuing more debt.

The rejection by the market of the rescue plan served asnotice to the EU community that there is little doubt that the only way toavoid the spread of contaminated debt in the Euro Zone is to implement furtherausterity measures rather than pile debt upon debt.

Tuesday’s weakness the Euro was also a strong indicationthat the market was discounting the inevitable that the debt of Greece, Spainand Portugalare getting very close to being declared “junk” by the credit rating services.

Besides the fear of contagion over the short-run, Euroinvestors are dealing with the real possibility that the bailout package willbe a drain on European economic growth. The implementation of the unprecedentedbailout package means that resources will be used to fill in “holes” in theeconomy rather than sow the seeds for future prosperity.

Flooding the market with excess liquidity will force theEuropean Central Bank to keep interest rates low for a longer period of time.As other major central banks begin to withdraw stimulus and hike interestrates, investors will shift investments out of the Euro Zone and into thesehigher yielding currencies putting additional pressure on the Euro.

Early during Tuesday’s trading session stronger gold, crudeoil and equity prices helped drive up demand for higher yielding currenciessuch as the Canadian Dollar, Australian Dollar and New Zealand Dollar. Althoughgold finished sharply higher, the sell-off in the stock indices into the closeturned the Aussie and Kiwi lower and helped the USD CAD trim some of its loss.

Higher equity prices also gave the USD JPY an early sessionboost, but this support caved in late in the trading session when U.S. equitymarkets failed to hold on to their earlier gains. Look for continued weaknessin the Dollar/Yen pair if stocks begin to retreat. Further weakness in higherrisk assets will drive nervous investors into the lower yielding Japanese Yen.