Pound Sterling's Rebound will Live or Die on How Much Further the Market Rally can Extend

• GBP in 6 days of consecutive gains
• Focus shifts away from UK fiscal policy
• Global market rally to determine near-term outlook
• Current rally could be a relief style rebound
• Meaning GBP strength could be limited

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The British Pound's recent recovery could extend if the improvement in global investor sentiment continues, but analysts warn this is a market recovering from oversold conditions and the comeback won't last.

The Pound has risen sharply over recent days with much focus being on the domestic fiscal policy shifts of the UK government; however, there is evidence this is a waning factor for the UK currency.

We reported Sterling sustained another strong bid following reports that Chancellor Kwasi Kwarteng would bring forward his 'fiscal plan' from November to October, in a signal to financial markets he is committed to the sustainable management of the nation's accounts.

But, reports emerged on Tuesday that this was in fact not the case, and the date remains unchanged. "Disarray in Team Truss becomes farcical. Huge confusion over crucial financial statement meant to reassure markets," said Channel 4 presenter and journalist Andrew Neil.

Yet, Sterling held its gains against the Dollar and other G10 majors, suggesting the markets might not be fazed by the emerging nuances of UK domestic policy.

Rather, global factors appear to be highly relevant once more: the headline S&P 500 index has put in its strongest two-day winning streak since 2020.

The Pound has strengthened thanks to its 'high beta' status, which means it tends to rise alongside stock markets and fall when they are in retreat.

"A currency is referred to as "high-beta" if it is sensitive to global risk appetite," says Kamal Sharma, currency strategist at Bank of America. "GBP's sensitivity to world equity market has risen... about 35% of the currency's fluctuation can be explained by changes to the equity index".

The Pound to Euro exchange rate rose 1.63% last week and is up a further 0.60% this week at 1.1458.

The Pound to Dollar exchange rate rose 2.90% last week and is a further 1.75% higher this week at 1.1354.

However, 2022 has seen global equities enter a bear market, a development that underscores the Pound's 16% loss against the U.S. Dollar and 3.60% loss against the Euro.

This sensitivity to sentiment is a result of the Pound relying heavily on the inflow of foreign investment capital to sustain its valuation, owing to the UK's long-standing current account deficit which stands at 5.3% of GDP.

If foreign investors are not buying UK equities and bonds then the Pound is at risk of decline, exposing it to bear markets such as that of 2022.

Above: GBP/USD (top) and S&P 500 stock index (bottom). To better time your payment requirements, consider setting a free FX rate alert here.

The near-term outlook for the Pound therefore could rely on how long the current September relief rally can continue, is it permanent or will it inevitably be sold into?

"Don't expect the risk rally to be sustained for too long," says Anders Eklöf, a strategist at Swedbank. "Investors will stay cautious ahead avoiding less liquid and volatile assets/currencies."

He believes the risk rally of the last couple of days should be primarily seen as a temporary correction of the oversold market.

"The Sterling comeback is built on thin grounds," says Eklöf. 

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Markets remain driven by a fear global central banks will continue to tighten monetary policy to the extent that a global recession ensues.

"Downside pressures on global growth continue with leading indicators pointing to recession in Europe in H2 and in the US in early 2023," says Las Olsen, Chief Economist at Danske Bank.

"Continued rate hikes by the Fed are tightening financial conditions significantly, which will increasingly take effect in 2023. Growth headwinds in China also remain strong from the zero-covid policy, continued property crisis and now weakening exports," he adds.

The Dollar is meanwhile the ultimate beneficiary of this combination of higher U.S. interest rates and strong demand for safe-haven assets as markets fall.

"The greenback's rally looks increasingly stretched and we think there is scope for further consolidation. But with Fed officials continuing to bang their hawkish drum, the key underlying driver of the dollar’s strength remains intact and the risk of a continued self-reinforcing dollar melt-up is high," says Jonas Goltermann, Senior Markets Economist at Capital Economics.

Analysts at investment bank Nomura said in a recent note, "the simple fact is that the escalated U.S. Dollar appreciation of late is effectively the U.S. 'exporting inflation to rest of world,' and has iterated the 'Our currency, your problem' dynamic of old, causing tremendous strains economically...and increasingly, metastasising in markets."

The note adds that "the velocity of things breaking around the world (Yen, Yuan, Euro, Sterling, SONIA, Gilts, MBS, Lev Loan deals, the entirety of the UK LDI / Pension complex) is obviously a 'neon swan' telling us that we are clearly now in the 'market accident' stage from the tightening surge".

The global environment, therefore, faces a wall of worry and, at the very least, the Federal Reserve must signal it is ready to slow down its hiking cycle for the pressure to ease.

Until then, the Pound remains vulnerable.