Pound / Dollar Pulls Back for Third Straight Day

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The British Pound's rally against the Dollar is dealt a setback as the U.S. currency responds to another rise in U.S. bond yields, reigniting analyst expectations for the Dollar to strengthen in 2022.

The Dollar was the outperformer on January 18 after the yield paid on ten-year U.S. treasury bonds spiked to their highest levels in two years, driving foreign investor demand for the improving returns offered on U.S. debt notes.

Yields are rising amidst an ongoing investor positioning for higher interest rates at the U.S. Federal Reserve in 2022 and 2023.

"We expect the US rate rethink - and this latest shift higher in yields reflects a push higher in the implied terminal rate, rather than just a faster pace of increases initially - to support the dollar in the first half of the year," says Kit Juckes, a currency strategist at Société Générale.

Above: GBP/USD at four-hour intervals.

• GBP/USD reference rates at publication:
  Spot: 1.3614
• High street bank rates (indicative band): 1.3238-1.3333
• Payment specialist rates (indicative band): 1.3490-1.3546
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• Set up an exchange rate alert, here

The Pound to Dollar exchange rate fell a quarter of a percent to quote at 1.3614, in what could be a third successive day of declines from the the 2022 high at 1.3749.

"The key driver remains interest rate differentials and this in turn suggests the dollar looks cheap. In particular, EUR-USD and GBP-USD look expensive compared to the recent shifts in 2Y yield differentials," says Daragh Maher, Head of Research, Americas, at HSBC.

Safe-haven demand for the Dollar came as stock markets slumped in the wake of the rising yields - lead by the technology heavy NASDAQ 100 - establishing a scenario where the Dollar wins on multiple fronts: not only do higher yields in the U.S. attract capital inflows and support the Dollar, but they also prompt safe-haven demand as investors exit equities and opt for cash.

Should this win-win dynamic for the Dollar become entrenched then further declines in the Pound-Dollar exchange rate could be expected.

"The US labor market is so tight that wage growth has started to fire up, igniting worries of a wage-price spiral and by extension leading market participants to fully price in four rate increases for this year. This has propelled US Treasury yields much higher, and when the bond market begins to rumble, it feels like an earthquake for assets such as equities," says Marios Hadjikyriacos, Senior Investment Analyst at XM.com.

Above: The yield paid on U.S. ten-year treasury bonds continues a steady march higher, signalling the end of pandemic-era 'easy money'.

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"Markets apparently turned lower on rising bond yields," says Neil Wilson, Chief Analyst at Markets.com. "The key thing to watch today as US traders return to their desks following the MLK holiday is whether the rout in bonds continues, or moderates."

Should U.S. bond yields continue to press higher the cost of financing dollar-denominated debt across the world will continue to rise, creating headwinds to a global economic recovery.

This would suit further gains by the U.S. currency while at the same time hobbling Pound Sterling which would require a broader global recovery to facilitate a recovery.

The Dollar entered 2022 amidst crowded positioning with investors and analysts alike positioning for further gains in the currency.

As can so often be the case with crowded trades, any counter move can drive a sizeable position unwind, which appears to have been a driver of recent Dollar weakness.

"Being long USD is already the consensus view amongst strategists on the street," says Bipan Rai, North America Head of FX Strategy at CIBC Capital Markets.

"Futures markets clearly highlight the degree of the greenback’s popularity with the net speculative skew in long positions over one standard deviation above the 3-year rolling average. Put simply, it isn’t as “cool” to be long USD these days judging by the conversations that we’ve had with clients," he adds.

But CIBC are committed Dollar bulls in 2022, saying the market is still pricing in too low of a terminal rate for the upcoming rate hike cycle at the Federal Reserve.

Furthermore, CIBC says the prospect of quantitative tightening at the Fed - whereby they reverse the effects of quantitative easing - are under-appreciated.

"This should be bearish for long-end US real rates, and supportive for the USD. In fact, we saw this happen during the last round of QT. The 10-year real yield rose from 25bps in the fall of 2017 to 117bps a year later. Over that same timeframe, the trade-weighted USD rose by over 7%," says Rai.