Pound-to-Dollar Rate to be Among "Chief Casualties" if a Significant Dollar Rally Unfolds

Modified: Tuesday, 24 April 2018 15:36 BST
Written by: James Skinner

- Sterling and Euro are most vulnerable to a resurgent US Dollar.

- Sharp rise in US yields may continue driving the greenback higher.

- Yield gap widest since 1970's and GBPUSD has history of 15%+ moves.

The Pound-to-Dollar rate will be among the chief casualties if the current US Dollar rally gathers pace, according to strategists at Société Générale, as a bearish technical picture combines with a deteriorating interest rate outlook to clobber the British currency.

America's Dollar has entered the new week on the front foot thanks to a rise in US bond yields which, now threatening to break above a key and pyschologically important level, could now fuel a further advance against the developed world currency basket.

US 10 year yields have risen steadily in 2018, from a low of 2.4% to nearly 3% Tuesday, due to an increase in the supply of American bonds and as markets continue to flirt with the idea that the Federal Reserve could look to increase the pace at which it raises interest rates in the months ahead.

This has put other currencies at a disadvantage, particularly those backed by central banks that are either sat on their hands or are only in the early stages of normalizing their monetary policies.

"Dollar bulls are rampaging with the bond bears. A combination of heavy Treasury issuance and higher inflation breakevens has driven the US 10Y yield to near 3%. Equities have gone wobbly again, though not yet in panic mode. The US dollar would get a significant bid if US yields can break through 3% without throwing risk assets into panic," says Alvin Tan, a currency strategist at Société Générale.

Inconveniently for the Pound, the Dollar's rally comes at a time when markets have been growing ever more doubtful that the Bank of England will deliver its second interest rate rise since the financial crisis next month, in May.

"Our technical strategists have also highlighted last week's weekly engulfing pattern on GBP/USD. This adds to the bearish technical picture on cable in addition to the probable double top. GBP/USD has turned negative this month despite the much vaunted 'seasonal effects'. Thus cable could be among the chief casualties if a significant dollar rally were to unfold," adds Tan.

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

Pound Sterling has been pummelled in recent weeks after Office for National Statistics data showed wages growing slower than was expected during February and inflation was shown falling faster than expected during March, which has led markets to conclude that a May interest rate rise from the BoE is no longer the sure thing they once thought it was.

BoE Governor Mark Carney heaped more fuel onto the fires of the Pound Sterling bears last week when he appeared to hint that the Bank may wait a few months more before it raises rates again, more or less confirming fears that were first stoked at the beginning of that week.

Accordingly, pricing in interest rate derivatives markets has about turned and now implies a May 10 Bank Rate of just 0.55%, which is equal to just a 20% probability of a rate hike from the BoE next month. This is down from an implied May 10 bank rate of 0.66% last Monday, which suggested a 65% probability of a rate rise in May.

Friday's first-quarter UK GDP data may provide some scope this pessimism to be curtailed if it shows the UK economy holding up better than economists and analysts expect, although period of inclement weather in late February is expected to have hindered growth during the period.

Above: Societe Generale graph showing CFTC positioning of traders.

"Dollar bulls are more numerous than seems consistent with CFTC data that suggest everyone is short dollars, long (in particular) EUR and GBP. I've plotted the CFTC positioning data [above], as a percentage of 3-year maximum positions," says Kit Juckes, chief foreign exchange strategist at Société Générale.

The fact markets were betting so heavily on a rise in the Pound-to-Dollar rate before the wages and inflation outlook soured last week is what leaves Sterling and the Euro so vulnerable to a resurgent Dollar.

This is because, when speculators recognise that both currencies are in danger of decline, the unwinding of those speculative positions would then fuel further weakness in both currencies relative to the Dollar.

"The 10-year yield gap between US and UK government paper stands at its least supportive level for GBP since October 1984 (when GBP was trading around USD 1.24)," says Simon Derrick, chief currency strategist at BNY Mellon. "GBP has a history of 15% plus y/y moves against the USD - in both directions."

Many economists expect US economic growth to gather pace in the second quarter and beyond as consumption is supported by President Donald Trump's tax cuts and other fiscal stimulus, although analysts are still divided over whether this will be enough to alter the market's expectations around longer-term US interest rates.

It appears this expectation for higher interest rates from the Fed than had previously been anticipated is driving US treasury yields, and the Dollar by extension, higher.

Federal Reserve rate setters already hinted in the minutes of their latest policy meeting that they could contemplate pushing US interest rates higher than previously anticipated, writing; "Several participants expressed the judgment that it would likely become appropriate at some point for the Committee to set the federal funds rate above its longerrun normal value for a time."

Recent bond market and US Dollar price action would appear to suggest markets may be increasingly of the same opinion. Although some strategists see the current push higher for yields and the US Dollar as just another temporary phenomenon that will ultimately prove to be shortlived.

"We prefer to view this as a bear market bounce in the Dollar (Trump won’t want to see the dollar rally extend too much) and look for renewed pressure on the dollar into mid May," says Chris Turner, global head of FX strategy at ING Group.

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