Pound-to-Dollar Rate Increasingly Vulnerable as Interest Rate Outlook Between UK and US Continues to Diverge

- GBP/USD currently trading down in the 1.36s ahead of May Federal Reserve meeting

- Stronger USD outlook amidst Fed plans to hike interest rates further

- Widening divergence on monetary policy between UK and US refelected in sell-off 

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A key highlight for the U.S. Dollar is this week's policy meeting at the U.S. Federal Reserve where it is expected policy-makers will confirm the prospect of multiple interest rate rises over coming months remains alive.

This whilst expectations for similar rises at the Bank of England continue to be pared back, creating a divergence that is likely to heap yet further downside pressure on the GBP/USD exchange rate.

The Dollar retains a firm bid on widespread expectations that the Fed will continue raising interest rates at pretty much the quickest pace of any major country in the world. Analysts do not expect a rate rise at the meeting tomorrow (Wednesday) more hawkish rhetoric paving the way for future hikes is a strong possibility.

GBP/USD may weaken if the Fed solidifies its stance as an expectation of higher interest rates will support the Dollar, since higher rates increase inflows of foreign capital from investors seeking somewhere lucrative to park their money.

The Federal Reserve will leave monetary policy unchanged this week but the case for higher rates remains strong, says @knightleyecohttps://t.co/dsMk3yM9Kc pic.twitter.com/0UJFSnM86v

— ING Economics (@ING_Economics) April 30, 2018

The lack of momentum in the normalisation of interest rates in the rest of world is as much to blame for the Dollar's outperformance as anything else because it has invalidated the whole RoW hypothesis (RoW meaning 'Rest of the World' catching up with America) which had kept the Dollar capped at the start of 2018.

"Let’s not forget that one of the reinforcing themes for a weaker trade-weighted dollar over the past year has been the expectation that non-Fed central banks would tighten policy in due time. Listening to central bankers over the past few weeks, markets can be forgiven for re-assessing long-held positions," says Bipan Rai, North America head, FX Strategy, at CIBC.

In no pair is this perhaps more clearly symbolised than in Cable, the name FX traders give to GBP/USD.

The Bank of England had increasingly looked like it was about to raise interest rates in the UK again, helping the Pound keep pace with the Dollar, however, a combination of dovish rhetoric from the governor of the Bank of England and substantially lower GDP growth in Q1 of only 0.1%, have seen market-based expectations of an interest rate hike at the May 10 meeting fall from the 90% level to under 20% currently.

The Pound got hammered in the process falling from a peak in the 1.43s to a current spot price in the 1.36s in only a matter of weeks.

The BOE's August meeting is now seen as the next most likely time for a rate hike - a considerable can-kick down the road.

"Last week's preliminary estimate of Q1 GDP as extinguished any lingering chance that the PC might raise interest rates at its next meeting on May 10," ," says Samuel Tombs, macro strategist at Pantheon Macro, adding, "Tepid growth this year will constrain the MPC, though we still think enough MPC members will be concerned that inflation pressures will emerge from the labour market soon to hike rates to 0.75% in August."

A May hike is highly unlikely because" the MPC has never raised interest rates when the estimate of quarter-on-quarter GDP growth for the latest quarter has been below 0.4%," says Tombs.

The fall in growth cannot all be blamed solely on the bad weather, because it was offset by an increase in energy use due to the cold and by a rise in oil mining and drilling due to the closure of the Forties pipeline - thus there were positive factors in the data too.

"Growth also slowed in February and March in sectors which haven't been sensitive to adverse weather in the past," adds Tombs.

But the strategist also stresses that the economy is not in meltdown mode either.

"Business surveys are consistent with employee numbers growing by about 1.5% year-over-year over the next six months. Banks still are very willing to lend and the recent rapid improvement in the public finances has given the Chancellor scope to loosen his grip on spending," says the macro strategist.

Of course, all this is dependent on the government negotiating a relatively benign Brexit deal - something we cannot take for granted, however, according to Paul Hollingsworth, senior Uk economist at Capital Economics, who argues uncertainty is set to remain high for some time in the negotiation process.

The Pound rose prematurely in March following the EU's tacit agreement on a transition period till December 2020 - it now appears 'nothing is agreed until everything is agreed' and there is still a risk the UK could crash out of the EU in March 2019 on the original deadline with devastating implications for Sterling.

In actual fact, the government still needs to pass a Withdrawal and Implementation Bill to get the transition to December 2020 legally ratified, and this scheduled for a vote in parliament in October.

"These are incredibly complex negotiations and it is possible (although unlikely) that there is no Withdrawal Agreement by March 2019," says Hollingsworth, "In this scenario, it is possible that the EU27 will agree to extend the Article 50 notifications, although it would require a unanimous vote, which would not be guaranteed."

The main impediment to the course of negotiations is the problem posed by the Irish border. There appears to be no easy, win-win solution to the problem. In either of the two most probable outcomes, the government will have to cross one of its negotiating 'red-lines' and make major compromises. If an Irish solution cannot be found in time the threat of a hard Brexit in March 2019 will begin to reemerge, and such a scenario would be disastrous for Sterling.

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