US Dollar Strength Could Trigger Next Leg Lower in Pound to Dollar Rate’s Decline

US Dollar Strength Could Trigger Next Leg Lower in Pound to Dollar Rate’s Decline

2 March 2016, 12:55
Vasilii Apostolidi
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The uncertainty posed by the EU referendum has pulled the rug from beneath sterling of late, but a fresh bout of US dollar strength could push the exchange rate even lower still.

The British pound has been under sustained pressure against the US dollar since July 2014 when an impressive run of US economic data crowned the USD as the ‘King of Currencies’ and saw the start of a major cyclical uptrend.

That strength in the US dollar has come to a halt of late though with talk of recession starting to enter the discourse.

In fact, JPMorgan warned that the US dollar could fall 8%should the US enter recession this year as the US Federal Reserve is forced to abandon its interest rate raising plans.

Regardless, the decline in the GBP to USD exchange rate has continued apace thanks to the EU referendum, we are actually seeing sterling at its lowest levels against the dollar since early 2009.

We need to cast our minds back to the 1980s to dig up levels below here.

So the baton of GBP/USD decline has been passed from the dollar to the pound.

Bet on the US Dollar in 2016

Could the US dollar be about to take back the baton and stimulate the next leg of GBP/USD’s move lower?

The USD is back in demand with talk of a US recession has so far proven premature with subsequent data releases confirming the US economy is firmly in growth territory.

The environment is thus set for the next stage in the US dollar’s longer-term uptrend argues analyst Richard Franulovich at Westpac in Sydney.

“It is rare to see a market effectively flat a currency at a time when the underlying economy is finally showing clear signs of closing its under-utilised resources gap. For the first time in many months the USD looks well positioned to mount a serious attack at the key 100 resistance level,” says Franulovich of the US Dollar Index.

The dollar index tracks the performance of the broader dollar by weighting it against its most commonly traded counterparts, with the EUR/USD being the largest component of the indexaccounting for 57.6% of the basket.

Deutsche Bank’s Alan Ruskin says he believes that even a maturing USD trend could extend for another couple of years, albeit at a much slower pace.

“The USD real broad TWI is within 5% of fully recouping its prior cycle losses, but will achieve much stronger levels than the prior cycle peak, if China’s currency depreciation accelerates even modestly,” says Ruskin.

Compelling Reasons to Back the US Dollar

Decent US data releases are forecast to maintain a positive bias towards the USD over coming months.

“US consumer resilience should keep the economy growing. Balance sheet adjustments since the crisis leave the US economy better placed than other G10 economy’s to weather shocks. US led risk-off environment is unlikely to be a dominant state of the world,” says Ruskin.

Furthermore, Ruskin argues that the dollar is relatively protected to downside moves in US interest rate expectations.

Much of the dollar’s ascent has been based on the expectation that US interest rates are to keep rising over coming years ensuring demand for dollars needed to access these improved yields continues to grow.

Even if data does slow, the Fed would have to react in a surprisingly negative manner to prompt notable USD declines.

“To be much more USD bearish, the market must price in rate cuts, inspired by US events with accommodative Fed policy that is not matched or exceeded elsewhere,” says Ruskin.

Such an about turn is unlikely notes Ruskin citing historical precedent in Federal Reserve policy making.

This should limit the USD’s downside under a worst case scenario suggests the Deutsche Bank analyst.

In fact it is more likely to provide significant upside if Fed rate hike expectations resurface.

This Upturn has Serious Legs

Westpac’s Franulovich lists least two compelling reasons that suggest this run up in the USD index has serious legs:

1) a number of data points in recent weeks signal that the US economy may be finally closing its under-used resources gap; and

2) speculative exposure to the USD has fallen precipitously in recent weeks. This suggests that the capacity for the vast foreign exchange market to enter fresh pro-USD trades is significant.

Indeed, it will take a significant push by the speculative market to break the US Dollar Index’s resistance at 100.

What we therefore now know is that there are enough participants on the sidelines to make the push happen.

The Risks to these pro-USD Views

There are however reasons as to why the Greenback may remain trapped in its recent ranges, and it is worth keeping tabs on developments here.

Some key bellwether commodities have been trending higher for some weeks – iron ore, crude oil and copper - “a background that is not typically consistent with sustained USD strength,” says Franulovich.

West Texas appears notably poised, a break through $35/bbl a potentially significant development that would open up a new higher price range with important implications for global markets.

Federal Reserve speakers have of late failed to inspire much confidence in the USD.

The NY Fed’s President Dudley most recently noted:

“I judge the balance of risks to my growth and inflation outlooks may be starting to tilt slightly to the downside. The recent tightening of financial market conditions could have a greater negative impact on the U.S. economy should this tightening prove persistent and the continuing decline in energy and commodity prices may signal greater and more persistent disinflationary pressures in the global economy than I currently anticipate.”

Balance Tilted Towards Further GBP/USD Declines

We read the balance of risks pointing to a stronger dollar over coming weeks, particularly if the euro is undermined by the ECB.

Should the rally in USD combine with another bout of Brexit-inspired GBP selling then the pound to dollar exchange rate could hit levels unseen in recent memory.

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