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Investec FX – Sterling-Dollar Outlook

02-Nov-2015

The Sterling-Dollar exchange rate has seen plenty of volatility in the last couple of years, flying high up to the 1.7 mark on UK GDP outperformance and US easing through QE, before tumbling back under 1.5 as the run ups to the Scottish Referendum and General Election caused Sterling weakness at the time the Fed ended QE and started talking about future raising rates.

The Pound looks set to be ‘Following The Fed’

The Sterling-Dollar exchange rate has seen plenty of volatility in the last couple of years, flying high up to the 1.7 mark on UK GDP outperformance and US easing through QE, before tumbling back under 1.5 as the run ups to the Scottish Referendum and General Election caused Sterling weakness at the time the Fed ended QE and started talking about future raising rates. Now though, the pair is in a particularly unusual spot. Both the UK and US are showing similar economic situations, low inflation, strong employment, rising wages, Service sector driven recoveries - and this has linked the fate of the Pound in many ways to that of the dominant Dollar.

We are seeing an increasingly strong pattern of the Pound trading in a similar, more muted manner, to the Dollar. When US rate hike expectations have moved forward or backward, the UK curve has followed on an underlying assumption that the Bank of England could follow the Fed’s first rate hike with one of their own (based on similar economic situations).
For example, when Federal Reserve officials delayed rate rises in the US in September due to soft inflation and Chinese slowdown – although the Dollar weakened against the Pound, the moves were not as large as with other currencies against the Dollar. Equally, the Pound weakened against the Dollar after the last FOMC meeting showing the Fed are still keeping chances of a December rate hike alive – but the pair stayed in recent ranges unlike other currencies that reacted more. This has kept the Sterling-Dollar exchange rate trading sideways in a range for most of 2015 (chart attached).

So the main driver of the pair in the coming months is likely to be whether the Fed raise interest rates or not in December – unless the UK suddenly sees a surge in inflation pressure forcing the Bank of England to act quicker. If we see a Federal Reserve hike, the Pound would initially weaken against the Dollar, but would likely would recover into 2016 as one would expect the Bank of England to follow suit. There is much less priced into the UK curve for future rate hikes, with a first hike recently not priced until the end of 2016, so there is plenty of scope for Sterling strength if those expectations are brought forward.

Of course, nothing is certain and other factors such as the looming UK referendum on EU membership could influence the Pound in the coming months. For example, we saw with the Chinese rout in September and continued downward pressure on commodity prices unexpectedly move currency markets, but under the above main scenario this would see the Sterling-Dollar exchange rate weaken to 1.5 or below on a December US rate hike (Investec Economics teams main scenario), with a recovery back into the mid-1.5s or above into 2016 as the market catches up with the UK rate curve pricing in earlier hikes than the current late 2016 / early 2017 expectations.

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