Don't get caught off guard by GBP

Amid the ongoing European debt crisis, the British pound has emerged as one of the unlikely safe-haven darlings for currency traders.

The pound has strengthened 3.4 per cent against the euro since the start of the year, and 7.4 per cent if measured from October last year.

To many traders, this is surprising, considering two major points.

First, Britain is going through its second recession in only three years.

Second, the Bank of England (BOE) has flooded the financial system with pounds through its quantitative-easing (QE) programme, to the tune of £325 billion (S$656 billion).

The main function of QE in any country is to lower yields by purchasing a large amount of securities (through expansion of the money supply).

Lower yields would then help to push interest rates down and, subsequently, boost lending.

All this is done in the hope that increased lending will give the economy a needed boost and, ultimately, stimulate growth.

With the unprecedented amount of cash injected by the BOE, coupled with the flight to safety of European traders and investors, it is not difficult to see why yields are at a record low.

In fact, according to the latest figures on British bonds - known as gilts - yields for 10-year gilts are already below 2 per cent, a record low.

In essence, the flow of funds from Europe is helping the BOE with another QE programme.

BOE is taking a hawkish tone for two reasons. First, the flow of funds from Europe actually "helps" BOE maintain its QE programme.

Second, inflation is still stubbornly high, although it is not being caused by stronger demand.

Although we see the pound strengthening in the currency market, we need to be mindful of the underlying factors behind the currency's strength.

In Britain's case, the strength of the pound is not due to fundamentals.

When we bear this in mind, we can be more prepared to take steps and short the currency should the tide turn unexpectedly.

Trade call 

Short EUR/GBP at 0.7995

EUR/GBP has been moving in a solid downtrend, clearing almost 400 pips since March 28.
On the hourly chart, prices are flirting with the "round" number of 0.8000.

This is a level not seen since November 2008. Going with momentum, our bias is for a short and we will make an entry when prices fall to 0.7995.

A stop loss of 45 pips is located above the Monday-morning gap because we do not expect prices to go above the gap again.

We will have two targets on this trade, exiting the final position at 0.7905.