Pound / Dollar Outlook: Uptrend Intact Following Fed Minutes
The GBP/USD exchange rate is still pointed higher we believe despite recent consolidation.
At the time of writing we are seeing this currency pair at 1.2956 - very much near levels we have been witnessing through the course of the past week.
The big danger to Sterling's strength against the US Dollar was always going to be the release of minutes from the US Federal Reserve.
The minutes were consistent with market expectations for a June interest rate hike, as "most" officials confirmed they believe a hike to be appropriate “soon”.
The FOMC discussed a proposal that would cap the run-off of bond holdings, with the cap raised at three-month intervals, implying a very gradual tapering process.
The modest post-release fall in the USD suggests that, if anything, the messaging from the Fed was slightly less hawkish than some feared.
Pound Underperforms but can Still go Higher
Sterling found little to grasp onto following the release of an update to UK economic growth data released on Thursday, May 25.
The ONS reported it had cut its growth estimate for the first-quarter of 2017 but markets note that other reports show activity in the second quarter has picked up notably. Hence, there was little Sterling reaction.
The week started poorly after opinion polls showed the Conservative party lead narrowed, increasing the political risk of Theresa May not winning a landslide victory and therefore having the mandate to manoeuvre in Brexit negotiations.
This, coupled with political unease and fiscal tightening in Washington, has led to a stalling, chaotic, sideways, consolidation in the GBP/USD exchange rate as the effects of both currencies weakening cancelled each other out.
“GBPUSD traded range bound yesterday but exhibited some choppy moves including a surge at the end of the London session before a retrace following USD strength on Trump’s budget announcement which included a $3.6bn cut in spending over the next decade,” say Barclays in a briefing to clients dated May 24.
Lloyds Bank Commercial Banking’s technical analyst Adam Wilkins meanwhile highlights the theme of the pair’s inability to establish a foothold above 1.30 in his most recent assessment of GBP/USD.
“GBP has been an underperformer – a theme of recent weeks – struggling to hold gains against the USD above 1.30. It has provided another reminder of the relatively poor liquidity conditions with the violent intra-day moves at times in the last week or so, last night up to 1.3034 on no real news a case in point."
The market has seen numerous attempts to rally through 1.3040-1.3080 resistance, "but the lack of a decisive break is arguably reinforcing the importance of this level to short-term participants, risking a sharper move if it does give way,” says Wilkins.
Midweek Forecast: GBP/USD Can Still Go Higher
Recently we highlighted the wedge – or ending diagonal – pattern forming over recent weeks.
These patterns are signs of reversal according to trading lore although so far the only compelling break lower, which happened on Friday 19, proved to be a false break.
The pattern remains compelling and still warns of more downside, but until we actually get more signs of a breakdown from price action itself the staircase of higher highs and higher lows indicates that from a technical perspective the pair remains in a short-term uptrend, which is marginally more likely to continue than not.
We have to assume a push higher is still possible despite the emergence of potential topping patterns, however, we would ideally seek a break above the 1.3050 highs for confirmation first.
Such a break would be expected to reach a rather limited target at 1.3125, just below the monthly pivot – a tough area of resistance.
The fact the Pound is more undervalued (-10%), according to Purchasing Power Parity than the Dollar (~0%) supports the bullish forecast, as it is likely to rise towards equilibrium whereas the Dollar could remain unchanged.
Purchasing Power Parity is an evaluation of whether a currency is over or undervalued versus its counterparts depending on the cost of the basket of goods in one jurisdiction compared to another.
If the same basket of goods costs £100 in the UK and $135 in the US, then the PPP exchange rate is 1.35. if the real exchange rate is only 1.30 then the Pound is probably undervalued and likely to rise over time to reach the PPP valuation.
The chart below shows currencies exchange rates in relation to their Purchasing Power Parity valuations (y axis), and in relation to valuations based on long-term real interest rate differentials (x axis).
Sterling is nearly -2.2% undervalued compared to long-term interest rates, whilst the Dollar, like PPP, almost perfectly reflects them.
US Fed Ahead
Concerning the fundamental agenda, the US Federal Reserve release the minutes of their latest meeting and markets will be poring over the information in order to ascertain where the Fed sees the economy moving.
A bullish assessment of the outlook could be just what the USD needs to get going again.
"Dollar bulls have been trying to arrest the decline in the greenback over the past two weeks, with little success, as eurozone data continues to flag up the general recovery in that part of the world. But today’s Fed minutes might provide them with the force they need to get the US currency moving higher again," says Chris Beauchamp at IG.
If the minutes can paint a more hawkish picture, then we could see the dollar index get moving back towards 9800, while chances of a Fed rate hike in June will be given a polish.
This should call into question the Pound to Dollar exchange rate's chances of breaking above 1.30, for the short-term at least.
"We see limited scope for dovish surprises as when it comes to today’s FOMC meeting minutes. In fact, today’s minutes should highlight that the committee saw the door for a June hike as open and we do expect the Fed to hike next month," says Manuel Oliveri at Credit Agricole.
This is regardless of increased uncertainty as related to US President Trump’s economic agenda.
After all, the Fed mostly refrained from basing its rate outlook on any Trump-related policies.
Nevertheless, such an outcome is unlikely to surprise markets says Oliveri, which are already pricing in a close to 80% probability of a June hike.
Nevertheless, "well supported central bank rate expectations are likely to put a floor below the USD and make current levels an attractive buy, for instance against the EUR and the JPY," argues the analyst.
