Pound to Dollar 'Far Value' Seen at 1.25 on 50bp Shift Lower in Relative Rates Warn Soc Gen

pound to dollar exchange rate 1

The pound sterling's recovery against the US dollar has over extended according to studies which place fair value as being lower than current levels.

  • Pound to dollar exchange rate = 1.4488
  • Dollar to pound exchange rate = 0.6902

GBP holds near multiweek highs against the dollar and multimonth highs against other major currencies, underpinned by fading worries of Britain exiting the EU at the June 23 vote.

There are suggestions that the GBP/USD will move higher on the delivery of an 'In' vote; but any bounces could make an overvalued currency pair even more expensive we are told. 

Finding a true value for the pound is typically done by observing where the currency is in relation to interest rates.

The correlation between GBP/USD and 2-year interest rate differentials between the UK and US remains particularly strong and therefore has useful predictive powers.

Even though this relationship has been tested by the EU Referendum, it's held up well.

2-year sterling rates are now over 20bp below US ones, something which we haven't seen since 2006 says FX analyst Kit Juckes at Societe Generale.

The far right of the below chart suggests that while sterling got ahead of itself earlier this year as Brexitmania took off, the pound has now bounced too much and is seen as being overvalued:

Pound to dollar fair value should be higher

"If you believe that whether the UK stays in the EU or not, rates aren't going to go up even if the Fed finally gets a hike or two out of its system, there's a lot of downside," says Juckes.

A 50bp move down in the rate differential would imply a “fair value” for GBP/USD at 1.25.

"That seems implausibly low but still, the only question is how to stay short through the vote - because I'll be even more bearish if the vote is to stay in the EU and sterling bounces," says Juckes.

Forecasting Further GBP/USD Gains Near-Term

The relative health of the UK and US economy, as gauged by fresh data, may become a more imporatant factor in the direction the pair take in the week ahead, although upside targets provide a slight bullish apriori bias.

The GBP/USD pair is likely to continue climbing towards its next major target at 1.4798 in the week ahead.

A bottoming pattern called an inverse head and shoulders (H&S) reversal pattern has formed at the lows, during the first quarter of 2016. It has an as yet unfulfilled upside target of 1.5000, however, resistance from the 200-day moving average at 1.4798 provides a nearer-term target.  

GBPUSDMay21

According to analyst Karen Jones at Commerzbank, the recent rebound from off key support at the H&S's neckline has made the outlook more bullish.

Whilst she sees a triangle rather than an H&S, the conclusion is the same:

“GBP/USD’s outlook is positive following the retest and recovery off the triangle support. The next resistance lies at 1.4665 and this guards 1.4798, the 200-day ma. The upside measured target from the triangle is 1.5085.”

Like them we see a break above 1.4665 as leading to a move up to the 200-day moving average (MA) at 1.4798.

At that point the MA will likely exert substantial resistance as traders will have placed counter-trend sell orders there to profit from the expected pull-back.

Dollar Recovery Looks to Establish

The dollar’s May recovery continues, with price on the dollar index moving back above the 50-day moving average for the first time since early March, confirming the uptrend remains valid.

When viewed at weekly chart level, the lows from 2015 represent major support.

“The brief dip below that support level and subsequent reversal to regain that support level, followed by further advance since suggests that the low printed on the 3rd May could well have been a key reversal low and that the dollar may continue higher from here over the coming weeks. For now, the long-term trend is still down for the dollar,” says Phil Seaton at LS Trader.

US Federal Reserve Members Driving Dollar Recovery

The recovery seen on the charts has developments over at the US Federal Reserve to thank - the Fed is telling markets interest rate rises are coming, thereby fuelling dollar buying.

Investors will continue to buy dollars in order to expose themselves to higher yielding US investments over coming years.

The minutes of April’s FOMC meeting had a hawkish tone, with most members judging that, if incoming data continue to perform well, it will “likely” be appropriate to raise the funds rate at the June meeting.

The Fed seems comfortable with the state of the economy: willing to look through the soft readings on Q1 activity and to put more weight on continued labor market improvement.

Yet the Fed remains split over the role external developments should play in the setting of monetary policy, with some members taking the view that the US economy is likely to remain resilient to external shocks while others “noted that global financial markets could be sensitive to the upcoming British referendum on membership in the European Union or to unanticipated developments associated with China’s management of its exchange rate.”

“To us, the important question is whether the April minutes aimed to send a signal about intended action at the June meeting or whether the Fed simply wants optionality. Our view is consistent with the former,” says Michael Gapen at Barclays.

To be sure, if markets price out a June hike, Fed action at the meeting could introduce unneeded volatility; hence, talking up possible action in June, but not committing to action, keeps the Fed’s options open.

Of course this creates problems for the US dollar in that any backtracking in intent could seriously undermine the recent rally.

“That said, in the details of the minutes and in the repeated references to June in the minutes and in recent speeches, we detect something closer to intent,” says Gapen.

The path to a June hike, in Barclays’ view, remains possible but the road is narrow; the data have to cooperate, financial conditions need to remain supportive, and the committee needs confidence to act in advance of the UK referendum on EU membership.

Analysts at the bank retain a view that a rate hike in July or September (their baseline) is more likely and look to Chair Yellen’s speech on June 6 for further guidance.

USD and GBP Themes For This Week

GBP/USD’s rally was driven mainly by the results of an IPSOS Mori Poll that showed the ‘Remain’ vote in the EU Referendum pulling ahead by an 18 percentage point lead over the Brexit camp (55% vs 37%).

Bookmakers continue to place a 75-80% chance on the UK voting to stay in the EU and they are a reliable gauge, having been right in the Scottish Referendum and the General Election.

The rally may requirte fresh stimulus to continue as a substantial quantity of Brexit losses over the last 6 months have probably now been recouped.

The Bank of England (BOE) estimated that about half the 10% drop – or 5% - in the last 6-months was caused by Brexit concerns, whilst UniCredit put the damage at nearer 8%.

If you go by the BOE figures the losses have probably been recouped; if by UniCredit’s 1.4900 would be about the level at which losses would be made back.

Data from US Futures Exchanges shows a heavy net short position against the pound, (short positions are trading positions which profit from the asset falling) and if these shorts positions are closed it could provide fuel for a further rally.

Nevertheless further growth in the pound-dollar pair may require increased expectations of the BOE announcing an interest rate rise. 

GDP first quarter second estimates, could provide that stimulus if they come out higher than the 0.4% expected.

The dollar also has the potential to appreciate, making the pair difficult to forecast, since the two could cancel out each other’s strength.

The Minutes of the April FOMC meeting changed everything for the dollar, after they suggested a high chance of the Federal Reserve (Fed) hiking rates at the June FOMC meeting.

This has been further supported by comments from Federal Reserve officials speculating on the likelihood of a June interest rate rise.

Now the focus is on data as this will be one of the final criteria required to make the Fed take the step to raise rates.

Next week’s main release is the second estimate of Q1 GDP growth out on Friday.

The preliminary ready fell short of expectations and disappointed markets by coming out at 0.5%, however, if the revision is higher (markets are currently forecasting a 0.8% upward revision) we could see some serious upward traction in the dollar.

Durable Goods Orders and Housing Data could also help swing things further in favour of a June hike.

The current chances of a move in June using market-based indicators, have risen from 4% to 28% in just three days, since the Minutes were released on Wednesday.

Nevertheless, some analysts, such as ING Bank’s Viraj Patel, have suggested even if data is strong, the global economic climate would also have to remain positive to support a decision to raise interest rates by the Fed, as such a move could dampen growth in emerging markets.

“Hawkish Fed talk from both Dudley and Lacker reinforced the idea that the June FOMC meeting is a “live” one, though neither markets (nor ourselves) are entirely convinced that the Fed will hike again ahead of the Brexit referendum in the UK. Yet, we suspect that US data will continue to develop in a constructive manner such that we may be faced with a phantom rate hike in June (ie, data supports the case for further tightening, but global headwinds will likely keep the Fed on hold).” Commented Patel in a recent note.

Data Hotspots

For the pound, the main data release will be GDP second estimates on Thursday, which are expected to remain at 0.4% in line with expectations.

For the US the same Q1 GDP revisions are on Friday, and forecast to rise to 0.8% from the preliminary estimate of 0.5%. Such a rise would no doubt help the dollar as it would further raise bets of a June rate hike.

Beyond that there is Durable Goods Orders and Housing Data out on Wednesday and Thursday. Again both could influence how ‘game on’ the FOMC are likely to be in June.