'Smile Theory' Pushes Dollar Yet Higher

Image © Adobe Images

Another jump in the value of the U.S. Dollar - the main driver of the impulse lower in GBP/USD - rests with a deterioration in global investor sentiment as opposed to developments in interest rate markets.

"While much of this year's USD strength has come from the impulse of rising USD-denominated interest rates, this latest phase of USD strength seems to be stemming from risk-off," says Stephen Gallo, European Head of FX Strategy at BMO Capital.

This underscores why it is so difficult to bet against the Dollar: it is a winner in all weather and this potentially invites further weakness in GBP/USD.

"According to the so-called 'smile theory' of USD movement, the USD tends to rally in moments of distress in financial markets. These risk-off movements tend to be spike-like in nature," says Gallo.

He explains the 'smile theory' also observes that the USD also rallies in boom periods when growth is out of hand because the USD generally rallies as the Fed raises rates, with the Fed generally tightening policy more aggressively than other major central banks.

"What seems to have happened over the course of less than a week is that we have transitioned from a Fed-on USD rally to a risk-off USD rally with no down time in between. We would assign most of the change in market tone to the latest developments in China," says Gallo..

Above: GBP/USD at daily intervals, with the Relative Strength Index below, indicating oversold conditions. (Set your FX rate alert here).

The above chart shows the Pound's relentless downtrend against the Dollar, but with the Relative Strength Index (RSI) in the lower pane.

The RSI now reads below 30 which is an indicator that the market is oversold.

As such, for oversold conditions to unwind some near-term relief could be in store.

That said, rallies will be sold into under current conditions.

"Sliding global markets boosted safer plays, pushing the U.S. dollar to fresh two-year peaks. The dollar rolled to 2020 highs against the euro and sterling, while it climbed to its highest in more than a month against the Canadian dollar," says Joe Manimbo, Senior Market Analyst at Western Union.

Manimbo adds "the buck remains in vogue, given a dreary outlook for global growth and mounting expectations for the Fed to deliver large inflation-fighting interest rates hikes over the coming months".

"Cable (GBP/USD) suffered a second straight beating, crashing to the low 1.27 area from 1.30+ levels early last week. The queen’s money is additionally vulnerable to the rapidly developing UK cost of living crisis, as proven by last week’s and this morning’s dismal eco data. It’s the lowest level for cable since September 2020," says Mathias Van der Jeugt, an analyst at KBC Markets

Global markets sold off at the start of the new week on news that Beijing could be the latest Chinese mega city to go into lockdown.

With authorities pursuing a 'zero covid' approach the prospect that the world's number two economy and global growth engine suffers a significant slowdown is elevated.

Further congestion of global supply chains is also likely, adding to already hot inflationary pressures.

This is ultimately supportive of the Dollar.