Momentum is with the Pound as it Strikes New Multi-Month Best Against US Dollar

"When an exchange rate has a trend, it means future moves are likely to be in the same direction as past moves" - BNP Paribas.

Pound Sterling's strong rally of late means the damage inflicted by the Brexit vote has now been erased; and there could be even more gains to come.

The Pound is buying as many US Dollars today as it was in the run-up to the EU referendum in June 2016 thanks to an impressive recovery predicted largely on Dollar weakness and Sterling strength amidst a dawning realisation that Brexit won't be a disaster after all.

The Pound-to-Dollar exchange rate started the year at 1.3506 and has hit a best at 1.4328 on Thursday, January 25, ensuring this year's gain stands at 6.0%.

Above: The Pound has erased the post-referendum decline against the Dollar.

"GBP stands out as GBPUSD is now trading at similar levels to the weeks running up to the Brexit vote, pushed initially higher by gilt yields and a function of the weak USD. The currency may also be benefiting from the fact that the UK is less affected by any trade rhetoric coming from the US," says Hans Redeker at Morgan Stanley.

The Pound's gains are widespread with the UK currency advancing against most G10 majors, only the Australian Dollar is bettering the Pound.

The GBP outperformance has taken many by surprise, not the least given that it has not neccessarily been accompanied by an improvement in UK data or a significant abatement of the Brexit-related uncertainty.

Yet, should we be surprised that Sterling is outperforming?

BNP Paribas - the France-based financial services giant - have a neat model that observes momentum is often a good indicator of longer-term trends in a currency, and for the Pound this is currently particularly true.

The above graph explains why Sterling is doing well at the moment - it simply has the momentum and when there are no major news events to drive a currency it is usually momentum that wins the day.

This momentum has proven particularly fortuitous in an environment of US Dollar weakness.

The BNP Paribas FX Momentum model measures the strength of a currency’s bullish or bearish trend, providing a score for each currency between +100 and −100. The larger the score for a currency, the stronger its trend appears to be.

"When an exchange rate has a trend, it means future moves are likely to be in the same direction as past moves," says a note from the French investment bank on the matter. "GBP momentum remains moderately bullish at a score of +26."

So could it be more of the same for Sterling then? As the above graphic shows positive momentum behind the Pound can certainly extend as it remains below 50.

Elsewhere, findings show USD momentum measure has reached extremely bearish levels, similar to September 2017.

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Outlook for the US Dollar

The Pound would not be as high as it is today were it not for the woes suffered by the Greenback. U.S. Treasury Secretary Steve Mnuchin’s comments that "a weaker dollar is good” ... "as it relates to trade and opportunities" generated a large depreciation in the USD as it confirmed that the US administration sees a weaker currency as being helpful to their attempts of rebalancing the US economy.

The US wants to support domestic manufacturing and boost exports, while trying to curtail imports, and a weaker Dollar would certainly help.

Analyst Richard Grace with Commonwealth Bank Australia says the recent decline of the Dollar comes "precisely in line" with their medium‑term USD forecasts, and more losses are likely.

However, it is time for a correction in the near-term.

"We believe a short period of USD consolidation is likely as market’s digest that the U.S. government is not endorsing a long‑run change to previous Administration’s 'strong dollar policy'," says Grace.

However, to Grace and his team it is clear that the Trump Administration is welcoming a short‑run decline in the USD because it is good for U.S. commerce.

"We re‑affirm our view that the USD is likely to continue its depreciation this year," says Grace.

However, the main reason for their long‑held view the USD would weaken actually rests with the the Federal Reserve which commenced the tightening cycle (by raising interest rates, starting in December 2015).

CBA have found that the USD typically depreciates as soon as the Fed commences the tightening cycle, and this longer-term trend still has further to run. However, CBA's target of 1.42 for GBP/USD by year-end has already been breached.

They see 1.37 as being more appropriate for the exchange rate in the near-term.

Rally Overcooked

CBA's forecast targets are just one signal that the Pound's rally might be getting ahead of itself, and a period of consolidation becomes increasingly likely.

Bank of America don't see Mnuchin's comments that prompted the latest bout of Dollar weakness as anything to get excited about, in short, what Mnuchin said is not new.

"We do not think that Treasury Secretary Mnuchin's comments earlier today signal a shift in the "strong dollar" policy. Rather, we see the statement in its entirety as reaffirming existing policy on the dollar as a reflection US economic fundamentals, while acknowledging a more competitive USD valuation situation vs. this time last year," says Ben Randol, G10 FX Strategist with Bank of America in New York.

Randol notes the media widely reported the first part of the statement as indicating preference for a weak dollar.

"However, we think that the second part referring to the dollar as a reflection of US economy is the relevant one that markets should be paying attention to with regard to the administration's longer-term stance on the Dollar," says the analyst.

Bank of America believe the US Dollar is due a rebound and will actually end 2018 notably stronger than at current levels. That they take this view of Mnuchin's comments is therefore not necessarily surprising.

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