British Pound Strength vs. Dollar not Justified: Capital Economics

The British Pound's strong run against the Dollar is unlikely to last warn analysts at Capital Economics. 

Sterling has risen by 3.86% against the US Dollar since the middle of December and has gained 12.29% against the US currency during the last 12 months with gains overnight seeing the Pound-to-Dollar actually breach the 1.40 level.

Above: Pound-to-Dollar rate shown at weekly intervals.

A good portion of the advance has the weaker Dollar to thank - the US Dollar index - a measure of overall Dollar strength against a basket of currencies - has fallen by 2% in January alone which takes its 12 month loss above the 10% threshold.

However, analysts at Capital Economics reckon the Dollar's woes are unlikely to persist as the Federal Reserve is likely to pick up the pace at which it raises interest rates in 2018, which might provide some renewed support to the US Dollar. 

If it does, the Pound-to-Dollar rate can probably be expected to retrace some of its recent gains.

Indeed, for Capital Economics, interest rates matter when it comes to GBP/USD.

“The Pound’s recent strength against the Dollar is not justified by either interest rate differentials, or Brexit developments, suggesting that it is more a story of broad-based dollar weakness,” says analyst Paul Hollingsworth with Capital Economics in London. "We don’t expect the pound’s recent rally against the dollar to be sustained."

Hollingsworth says it looks hard to justify the Pound-to-Dollar exchange rate's rally based on the recent moves in relative interest rate expectations, which have actually gone in the opposite direction.

"It is also difficult to pin the rise on any reduction in Brexitrelated uncertainty. After all, there has not been any major breakthroughs since December’s European Council meeting," says Hollingsworth.

Capital Economics forecast the Pound-to-Dollar rate will end the 2018 year at 1.3500 while the Pound-to-Euro rate will end the year at 1.1700.

This suggests the Pound could fall by close to 3% against the US Dollar but rise by a little over 3% against the Euro during the rest of the year. 

Readers can learn more about what other analyst think 2018 has in store for the Pound here; Compilation of Major Bank Forecasts, Currency Views for 2018.

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A View Shared by Others

It's not just Capital Economics who believe the Dollar might yet retake lost ground against the upstart Sterling.

Of concern to some analysts are that we have a year of Brexit negotiations ahead, and the road ahead for Sterling is frought with pitfalls.

"Having briefly hit its post Brexit-high around 1.40, the British Pound’s recent rally may have run its course. Much of the optimism stemmed from positive Brexit commentaries rolling back hard Brexit fears towards securing a trade deal. The reality ahead is that hurdles will return once UK and EU start negotiations to finalise the Brexit deal this year. It is still too early to count the chickens before they hatch," warns Philip Wee, FX Strategist with DBS Group Research.

And then there are those who believe the US Dollar - which has been a laggard for a year now - is oversold and will ultimately perk up.

We reported at the start of the week that analysts at Bank of America Merrill Lynch Global Research are believers in the Dollar's ability to make a comeback, saying they "continue to think the market is ignoring USD upside risks in the first half of the year".

According to Kamal Sharma, based in BofAML's London office, traders might not fully appreciate that a cocktail of stimulus is about to hit the US economy from a mix of repatriation flows by corporates and lower taxes more widely.

"Repatriation of accumulated earnings held overseas in local currency by US corporates the result of tax reform passage could result in up to $400bn worth of USD inflows according to our estimates," says Sharma.

Furthermore, BofAML are forecasting three interest rate rises in 2018, ahead of market consensus estimates for just two rate rises. This should make the gaping differential between UK and US yields create even more of a downward pull on GBP/USD, as per the graph supplied earlier in this piece.