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Challenges and Opportunities for GBPUSD in 2018

Posted on: 23 January 2018 , by: Darren Sinden , category: Market Review

The UK economy finished 2017 in better shape than many commentators had predicted. 

However, growth was slowing and as a consequence, that growth was at lower rates, than that seen from the UK's European peers. Though it should be noted that many of those were bouncing from a very low base. The UK currency rallied throughout 2017, having traded down to $1.1986 in late January. It would finish the year at $1.3513; a gain of some 11.5%, in what many would have considered the most unlikely circumstances for a rally. 2018 will not be without its challenges, from both an economic and political standpoint. Though the political challenges are being put into context by events in Europe; namely the lack of German government four months after an election, Catalan separatism and the prospect of another indecisive general election in Italy, of March this year.

In this article we will look at the challenges as well as the opportunities for the British Pound from both a fundamental and technical viewpoint. As well as trying to identify any data or metrics that we can use to determine what future moves in the Sterling-Dollar exchange rate may be.

Fundamental Factors

The Aftermath of Brexit

There is no avoiding the elephant in the room as far as the UK currency is concerned. Brexit is the dominant factor. However, we did see some progress and even an agreement between the UK and Europe in the closing stages of 2017. It would be naive to think that there won't be further issues, as talks move onto more substantive matters such as trade. 

HSBC Bankers recently conducted a poll among institutional investors, and 75% of their respondents named a “No deal Brexit” as their top market risk for 2018. In fact, it came in ahead of a funding squeeze in the USA or a credit crisis in China. That said, while investors saw danger in a "No deal" scenario they do not believe that outcome to be very likely. This suggests that they are hoping for the best while planning for the worst; which is how any successful trader should set out their stool.

An Optimistic Outlook

It's interesting to note that the FX market is more optimistic about the prospects for Sterling and the UK economy than their interest rate counterparts.

The differential between one year Sterling and US Dollar swaps implies that Cable should be trading closer to $1.15 than $1.35. One can find a similar scenario between the EURUSD FX rate and the implied exchange rate derived from Euro and US Dollar swaps. This suggests to me that the issues in this regard are on the other side of the Atlantic, perhaps in Washington DC. That is all supposition of course, but if we look at the performance of UK and US government bonds, using ten-year benchmarks, we find some support for that notion. 

 

Prices of UK 10 year government bond futures vs their US counterparts

The chart shows that since October last year, investors have been happier to hold UK bonds at higher prices when compared to those for US bonds. There was a brief correction in December after the Federal Reserve raised interest rates, but since then the gap has started to widen once more. Bond prices and their yields are directly comparable to the borrowing costs that underlying governments face in the open market. This is because the higher the price of a bond, the lower it's yield or return will be.

Such yields are also the effective interest rates at which a government can expect to borrow money at. Put simply, it seems that the market is currently happier to lend money to the UK government for a smaller return than it demands from the USA. And that is a vote of confidence in the UK, and it's currency if it's anything at all. Or perhaps we should interpret this as a lack of confidence in the USA, or at least it's political administration.

The budgetary ramifications of Donald Trump's recent tax cuts are still being debated, and the country’s Debt to GDP figures which stood at 106.1% at the end of 2016, may well rise once more as a result of those cuts. I note that this ratio is already the fifth highest in the world. 

The question for FX traders, therefore, is this; will the US state benefit from a continued economic in the country or will the private sector reap all the rewards? As is the case against the Euro, where the most likely reason for the Dollar to rally would be a steeper rate rise curve from the Federal Reserve in 2018. That may largely depend on the new appointees to the Federal Open Markets Committee or FOMC, and in particular incoming chair Jerome Powell. 

Technical Outlook

As we noted above, Gold finished 2017 on a positive note. It posted a hammer formation on the daily candle chart on the 12th of December, under which the price is said to be beating out at bottom. Gold posted a low of $1236.49, and then it rallied in a straight line to end the year a fraction over $1303 per ounce, and traded above $1320 early in the New Year. This was a textbook bounce after a hammer formation. It was also accompanied by a pair of golden crosses, as the 20 day EMA moved up through it's 200 and 50-day counterparts, a sure sign of rising price momentum. 

That Rally has however taken the daily RSI 14 for Gold into overbought territory, from where a short-term correction now seems likely. A pullback in Gold to $1305 and perhaps the Jan 2nd low of $1302.20 could be accommodated without completely derailing the rally I feel. Not least because there has been historic support/resistance at and around these levels during 2017.

GBP USD Weekly Chart

As we have already noted, Sterling has had the upper hand in the Cable relationship, over the course of 2017. We must now ask ourselves if the UK currency can retain and build on that momentum and make further meaningful gains. One early Sterling's upside credentials can be found at $1.3572, the opening level for Cable from the 22nd of September, a day which saw the pair print a high of $1.3657. Sustained moves above these levels could open the door to a $1.40 handle for Cable and arguably to a retest to the high of June 24th, 2016 at $1.5018.

ING, a Dutch bank with a very good track record in FX predictions, has gone on record to say that this could well happen. Thanks to the rally in the British Pound, from March 2017 onward, there is a gently sloping uptrend in place for Sterling on the Cable chart, which comes in currently around $1.352, and the Pound is further supported by the 200 day EMA line at $1.3130. The Cable rate had largely respected that line since June last year, it's 50-day counterpart is found around $1.3360 at present, and the faster moving 20 day variant at $1.3428. Sterling is not overbought on an RSI 14 basis with a reading in the low 60s currently. And regarding its performance in my model, GBP is a mid-strength bull trend with a target of $1.37 versus the Dollar. Among the basket of 11 Sterling FX rates the model tracks the trend strength of Sterling, which is only higher than this in one instance, and that is versus the Yen. Against this, however, the trade weighted basket, the Sterling Index (of which the Dollar is one of the largest constituents) peaked in early December, at 74.13 and has trended lower since. It may have found support at 73.20 (see the blue line on the chart below).

UK Sterling Index vs. US Dollar Index

In summary, there are quite a few known unknowns as far as the Cable rate is concerned for 2018. Brexit is foremost among these of course, and the likelihood is that the next round of negotiations will be far from easy, for the UK Government. But as we have noted, markets seem to believe that deal will be forthcoming. Markets are also warming to the idea of a rate rise in the US as early as March, and that is quite a dramatic shift from June 2018, which was their go-to date before Christmas. However, the market does not appear to be anticipating any more than three rises in 2018, which is inline with the Feds stated position. That might go some way to explain the absence of a positive reaction from the Dollar. Sentiment towards Sterling and the UK will be the key for Cable. That could largely be driven by Theresa May's standing in the UK parliament, the chances of fresh elections resulting in Labour administration under Jeremy Corbyn. If that were to start looking like a real possibility, then the good work that Sterling did in 2017 could all be undone at a stroke.

 

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