Written by Jamie Saettele, Senior Currency Strategist; John Rivera, Currency Analyst; Ilya Spivak, Currency Analyst*
GBP/USD Monthly Technical Forecast
The rally from 1.35 in the GBPUSD is probably just the beginning of a 4th wave correction. 4th waves commonly unfold as triangles. In this case, Cable would trade in a tightening range (at lower levels) for probably the rest of the month. Immediately, expect weakness in wave d of the triangle towards 1.40. Bottom line; a consolidation and break below 1.35 looks likely before an important low is in place.
GBP/USD Interest Rate Forecast
Now that the BoE has brought their benchmark rate down to a record low of 0.50% we have seen the interest rate expectations spread between the U.K. and the U.S. shrink considerably. Credit Suisse overnight index swaps have gone from pricing in another 12 bps of cuts to a 39 bps increase for the U.K. which has reduced the difference in expectations from -53 to +6. Although this is a bullish signal, with interest rates near zero, they have lost some of their predictive value for currency pairs. Nevertheless, improving fundamentals and stabilizing inflation in both countries will lead to increasing interest rate expectations Nevertheless, improving fundamentals and stabilizing inflation in both countries will lead to increasing interest rate expectations. If the U.K. shows signs of emerging from the downturn first then the pound may see its yield advantage increase over the coming months which could be bullish for the pound.
However, the ECB also forecasted that they would make a decision on taking quantitative easing measures which could be a weighing factor for the Euro and wouldn’t be reflected in the interest rate outlook. Therefore, traders shouldn’t assign significant weight to yield differentials when making trade decisions.
The chart below emphasizes the strength of the relationship between yields and currency movements over the past twelve months of trade. The US yield advantage peaked in July 2006, allowing the GBPUSD to set a firm bottom and reverse its previous downtrend. The currency pair subsequently scaled 15-year highs when UK short term rates surpassed their US counterparts through the first quarter. However, with conditions in the UK economy likely to deteriorate in coming months, creating the potential for a decrease in UK interest rates, there remain downside risks across the GBP pairs.
British Pound – US Dollar Valuation Forecast
Aggressive selling over recent months has seen the British Pound slip below its PPP exchange rate into undervalued territory. All signs point to the likelihood that the disparity will intensify before prices move back in the opposite direction as the US Dollar continues to be highly correlated with trends amid what the IMF expects to be the worst global downturn since the Second World War. The international lending body has further forecast that the UK will see the deepest recession of the G7 nations, suggesting rates will be comparatively slow to move back higher and giving the greenback an additional advantage. While the bottom line is bullish from a strict valuation standpoint, it seems prudent to remain on the sidelines for the time being until a greater value gap emerges.
What is Purchasing Power Parity?
One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by the Organization for Economic Cooperation and Development (OECD). We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar. Currencies pairs that are undervalued against their PPP exchange rate have the size of the value gap denoted in RED, while those that are overvalued are denoted in GREEN.
*Any opinions, news, research, analyses, prices, or other information contained on this website is provided as general market commentary, and does not constitute investment advice. FXCM Holdings LLC will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.