More Gains for GBP/USD Exchange Rate Forecast

Pound Sterling powered to its strongest levels in five weeks against the Dollar as markets eye bond markets and the budding of a potential Reagan-Thatcher remix between Trump and May.

The GBP/USD and traded to 1.2608 by the time markets closed on Friday November 11th having recovered from the week's low at 1.2352.

The UK currency managed to outperform its American cousin, despite the Dollar also having a blinder of a week.

"GBP is turning into a 'darling' currency post US election, managing to rally against the USD through recent range highs ~1.2550. Next resistance lies in the 1.2645, while key medium term resistance is above in the 1.28-1.30 region. We are still biased for a medium-term range to develop and expect to see that upper resistance area capping in this regard," says analayst Robin Wilkin at Lloyds Bank.

The surge through resistance at 1.2557 is quite remarkable, particularly as the US Dollar itself is having such a good time on global markets.

In fact gains for Pound Sterling have come right across the board which confirms to us that the Trump victory has shone a light on the fact the currency had been oversold in the months following the Brexit vote.

“The only currency in our sample that beat the mighty USD this week was Sterling, thanks a combination of continued short covering and some speculation about the UK's improved Brexit negotiating position with a potential US downgrading of its NATO commitments,” says Alvin Tan, analyst with Societe Generale in London.

Investors Close the Gap between GBP/USD and Rate Differentials

It usually takes a big event to shift market focus in a fundamental manner and this week we witnessed such an event. 

Donald Trump's victory has triggered what is widely dubbed as the reflation phenomenon - this is where markets price in higher inflation over coming years as the new President is tipped to embark on a massive plan to stimulate the US economy.

This has driven government bond yields higher as investors demand more payback for holding assets that could be eroded by inflation over coming years.

Importantly this has also impacted UK bonds. In fact UK Gilt yields are rising faster than yields in the US and Eurozone are.

Markets are betting that the Bank of England will have to raise interest rates more than previously anticipated since Trump's policies are now likely to be fulfilled.

The outperformance by UK bonds is finally pulling the Pound higher.

In understanding the Pound's impressive bounce it must be noted that since the Brexit vote the Pound and Gilt performance have detached and a chasm has emerged between UK Gilts and the Pound:

The above shows that the value of GBP/USD is ultimately a function of the movement in direction of the difference between US and UK bond yields.

However, Brexit has shaken this relationship up as markets allowed fears of a post-Brexit economy to let them lose sight of fundamental valuations.

Therefore, the Pound was considered undervalued heading into the US elections.

We have warned that this gap must ultimately shut; and it looks like Sterling is now finally playing catchup as global bond markets react to Trump.

A US-UK Trade Deal on the Cards?

As mentioned, another factor potentially driving Sterling outperformance is the prospect for improved trade relations with the US.

Trump has made it clear that he favours the UK's decision to vote for Brexit while there are hints he wants to nurture a power-couple relationship with PM May that bears a resemblance to that between Reagan and Thatcher in the 1980s.

"I think the Pound could be particularly positive on a Trump presidency because he has warmly extended the hand of friendship to Theresa May and wants to see her first when he actually takes up the Presidency in Jan," says Kathleen Brooks at City Index. "This opens the door to an earlier trade deal with the US, compared to what Obama offered, which could make our economic prospects outside of the EU much brighter."

Furthermore, reports have come in that Vice President-Elect Pence made a phone call to the UK's Foreign Secretary Johnson the first on his to-do list.

The talk centred on bulding stronger US/UK ties and for a new administration that prefers bilateral trade deals as opposed to bloc deals, this could really be beneficial to the UK as it leaves Europe.

More Gains for GBP/USD Ahead

What those hoping for a stronger Dollar should be looking out for is a break of that resistance line at 1.2557.

As can be seen the line has been tested on three occassions in November yet the bulls have failed to crack higher.

This tells us there is a good supply of Sterling at this level and the pair could struggle.

It also tells us though that if the level is overcome there could be some clear air to higher levels.

Analysts at JP Morgan see the pair heading higher to between 1.2600 and 1.2850.

Using Elliot Wave analysis, which is a type of cycle analysis, JP Morgan expect a correction higher up to the aforesaid band in a wave 4, before moving lower again in a final wave 5 down.

Elliot Waves are composed of 5 waves, with 1,3 and 5 in the direction of the trend and 2 and 4 against the trend and corrective.

Once the 5-wave cycle has ended the pair will make a much larger correction against the dominant trend, as the cycle turns.

Pound Gains to be Limited as US Dollar has Higher to Go

Analyst Eric Theoret at Scotiabank is nervous about the Pound's ability to outperform its larger cousin going forward.

Markets are buying Dollars to invest in US stock markets as markets reckon a Trump presidency could deliver an acceleration in US economic growth with the  President-elect having promised in excess of $500BN being channelled to infrastructure spending.

Of course, whether these plans pass through Congress is another matter, but what markets do like is the promise of lower taxes with corporation tax potentially being slashed to 15%.

To coax multinationals into repatriating their vast foreign hoardings Trump also promises an amnesty for any returns.

Such a huge inflow of foreign exchange is immediately Dollar-positive in itself.

"With the promise of a tax repatriation scheme for multinationals, lower tax rates and higher government spending, it seems the markets are waking up to the chance of a growth driven economic period for the US,” says  Joshua Mahony, Market Analyst at IG.

US Dollar in Demand as Fed Rate Hike Tipped for December

One of the characteristics of the pre-election financial market space was that a Trump victory implied the Fed shying away from raising interest rates at the December meeting.

The thinking was that uncertainty would prompt the Fed to hold back on raising rates which would naturally see the Dollar lose support.

However, overnight, San Francisco Federal Reserve Bank President John Williams said he still believes gradual U.S interest-rate rises make sense even after the surprise election of Republican Donald Trump as the next U.S. president.

"I don’t see any change in how I approach monetary policy. It’s really driven by the data," Williams told reporters after speaking with students at the University of San Francisco on Wednesday, the day after the shock election result.

"The argument for a gradual rate of increases still makes sense to me."

Markets have taken this as confirmation that the Fed will go ahead with rate hikes which should keep the Dollar buoyed.

“We expect the Fed to deliver a hike in December, as the economic data have been indicating. Furthermore, we believe the Fed has no interest at all to become politically tainted by refraining to hike as a result of the US election. Of course, this is contingent on the sell-off being rather mild and short-lived,” says Christian Schwarz at Mizuho Bank in London.

Others agree.

“We continue to expect the Fed to move rates higher in December. The odds are lower as uncertainty is higher, but the near-term impacts on growth and inflation are small absent a sustained financial market shock. Any risk to the Fed outlook is to the path of policy in 2017 and 2018,” says Drew T. Matus at UBS.

Long-Term Decline in GBP/USD Forecast to Ultimately Extend

All the signs therefore point to a firm Dollar as markets move forward.

“Interest rate differentials are widening and risk reversals appear set to turn with a potential for a renewed rise in the premium for protection against GBP weakness. We are bearish GBP,” says Eric Theoret at Scotiabank.

So how far could the exchange rate decline?

From a technical perspective we are told 1.05 could be a long-term target that the GBP/USD could aim for.

"The long-term technical pattern is even more negative since the Brexit vote has paved the way for further decline. Long-term support given at 1.0520 (01/03/85) represents a decent target," says Yann Quelenn, a Market Strategist with Swissquote Bank.

According to Quelenn, long-term resistance is given at 1.5018 (24/06/2015) and would indicate a long-term reversal in the negative trend., "yet, it is very unlikely at the moment".