Where Next for GBP/USD?
After flirting with the $1.60 level against the US dollar early this month, sterling has started to retreat – dropping dramatically over the past two days. Is the GBP/USD pair set to continue to tumble or are there still reasons to be bullish about the pound?
The Fed’s decision not to increase quantitative easing, announced on 10 August, may continue to help the dollar strengthen in the short-term. However, there are still a number of issues that may scupper a rally on the buck, not least the looming spectre of deflation. Equally, while sterling has gone through something of a purple patch of late, rising strongly from its year-low of $1.43, which it hit just after this year’s General Election produced a hung parliament, growing doubts over the strength of the UK’s economic recovery may hamper progress.
In short, any discussion of Cable can seem like a game of trying to find the least weak of these two major currencies. That’s not to say there is a dearth of trading opportunities; the last two days have seen huge, triple-digit fluctuations in the pair, with sterling giving up more than 200 pips against the dollar on 11 August alone. We examine some of the issues surrounding the GBP/USD pair.
The dollar ‘carry trade’
A seemingly stagnating US economy has once again raised the prospect of a dollar carry trade, in which investors profit by taking advantage of the long-term low borrowing costs in the US to invest in higher yielding assets. If this were to happen to any significant extent, it would signal an incredibly pessimistic view of the US currency, as a weakening dollar would make this position even more profitable, whereas a stronger dollar would make it a risky trade.
However, even if it were to happen, such a trade is unlikely directly to benefit the pound, which would be an unlikely investment choice given the UK’s own low interest rates and weak growth prospects. As such, the effect on GBP/USD might be comparatively insignificant.
There is also the counter view that the dollar is in fact in a position to claw back its recent losses and that the Fed’s relatively staid response to economic weakness is testament to a fundamental resilience in the US economy, despite slowing growth. The lack of further QE will keep markets on edge as traders second-guess what the Fed’s next move may be.
Can the pound continue its long-term recovery?
Sterling has come a long way since May, reaching its highest level against the US dollar for 10 months on a trade-weighted basis at the start of August. However, there is a fine balancing act in progress as the UK government aims to reduce the budget deficit without causing the economy to stall. While the deficit harms sterling’s performance on the forex markets, a slowing recovery will also tend to lead traders away from the UK currency.
More positively, the rally that took the pound towards $1.60 was fuelled, at least in part, by strong corporate earnings in the financial sector, which now looks to be in fairly robust health. Equally, if the government’s tough emergency budget can continue to slash the deficit without causing structural harm to the economy, we may see further upside on the pound. Our Chief Market Strategist, David Jones, said that the ‘recovery [for sterling] still looks to be intact while the forex pair remains above 1.5000’, adding that ‘many technical analysts are eyeing up the 1.6500 area as the next interim target.’
In terms of its relationship to the dollar, sterling may also rise due to some recent weakness stateside. The dollar’s gains against the pound over the past two days are arguably nothing more than traders pricing out further quantitative easing in the US – something which had been widely predicted following the latest disappointing non-farm payroll figure.
Take a position
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Updated: 12/08/10
The above comments do not constitute investment advice and IG Index accepts no responsibility for any use that may be made of them.
* Tax law can change or may differ in a jurisdiction other than in the UK
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