Three Factors Driving the GBP/USD Exchange Rate Back Above 1.27

The GBP/USD exchange rate strengthened into the weekend with Sterling buying as much as $1.2745 on the inter-bank markets.

The exchange rate had been as low $1.2589 earlier in the week before closing the week at $1.2716.

So what could be driving the recovery in Pound Sterling, and can these factors continue to deliver gains?

We believe there are three drivers:

1) Latest developments in the Brexit process

2) More chat from the Bank of England

3) Broad-based US Dollar weakness

May Oils Early Stages of Brexit Talks

Investec’s dealing desk suggests it could be hopes of a ‘softer’ Brexit deal in which the UK would not lose access to free trade with the block, after Theresa May’s announcement that the government was offering EU negotiators in Brexit talks a deal which would allow EU citizens who had been living in the UK for over 5 years ‘UK Settled Status’.

This would entitle them to access to healthcare, education and housing and possibly even residency for life.

May offered fellow EU leaders a "fair" deal on Thursday for compatriots living in Britain after Brexit. She described the plan as a "a fair and serious offer", that is "aimed at giving as much certainty as possible to citizens who have settled in the UK, building careers and lives, and contributing so much to our society".

Promising further details on Monday, May also suggested that those EU citizens who had lived in Britain for five years could stay for life.

This suggests to us the UK is serious about pushing negotiations forward to try and avoid the prospect of having no trade deal in place by the time the UK exits the EU in 2019.

However, European Commission President Jean-Claude Juncker has since dismissed the move as insufficient; something that should not come as a surprise.

Juncker's relationship with the UK has long been antagonistic - the UK's opposition to him being elected President of the Commission in 2014 will have certainly fueled this - and he will be seeking the worst possible outcome for the UK.

The uncertainty will surely keep any strentgh in Sterling limited.

The Forbes Factor

Another possible driver for the strong Pound could be the content of the outgoing speech from Bank of England (BOE) official Kirsten Forbes.

Forbes repeated that she thought the Bank needed to raise base interest rates to counter rising inflation.

This would strengthen the Pound as higher interest rates attract more capital.

“Forbes said the UK’s “failure to launch” on raising interest rates is no longer justified, in part because of the resilience of the British economy,” commented Investec.

Forbes appeared to dismiss her boss Mark Canrey’s argument that real earnings were too low to raise rates, arguing that although the main driver of inflation had been the weak Pound, this was still no reason to hold off from increase rates.

“Forbes argued the depreciation in sterling had reversed the trend for inflation, generating “more persistent inflationary pressures and providing a powerful reason to raise interest rates now,” said Investec.

Her ‘hawkish’ comments (hawkish means in favour of higher interest rates), were in direct contrast to Mark Carney’s at his Mansion

House speech, where he said wages were too anaemic and growth too low to allow for higher interest rates.

A speech by chief economist Andy Haldane on Wednesday also supported raising interest rates, and commentators are speculating as to a possible serious rift between hawks and doves within the BOE.

US Dollar falls on Unfavourable Outflows

The other side of the pair, the Dollar, meanwhile traded softer due to increasing outflows to riskier and/or higher interest bearing assets which offer greater returns – such as the Aussie or New Zealand Dollars, or emerging market assets.

“The US dollar is offered against all of its G10 counterparts. The antipodeans are the biggest gainers. The euro and the pound are well bid as the European traders step in,” said LCG Capital’s senior market analyst Ipek Ozkardeskaya.

Softer US yields were the main reason for the outflow as they encouraged increased carry trading.

Carry trading involves borrowing in a low interest rate bearing currency such as the Yen and reinvesting in a higher interest rate bearing currency such as the New Zealand Dollar, the trader thus profiting on the difference.

“The USD dollar pared losses against its EM counterparts, yet the bias remains in favour of the higher yielding currencies. The lack of appetite to push the world’s most popular equity indices to new record levels could drive some more capital into well remunerating money markets,” said Ozkardeskaya

An improved outlook for both the Australian and New Zealand domestic economies seems to be behind the lurch back to antipodeans via the carry trade.