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GBP/USD risks 1.3160 if the Fed rate hike story gathers traction, something some analysts see happening.
The RBNZ on Wednesday sent a warning signal to markets: rates must rise to counter inflation, the implication being that the Federal Reserve could follow suit in adopting a similar 'hawkish' stance.
The RBNZ's just-released policy decision saw policymakers indicate up to three rate hikes were potentially necessary to stay on top of bubbling inflationary pressures, a stance that understandably boosted NZD.
The RBNZ often leads other central banks in the major cycles and signals a looming shift at the Fed that would strengthen the dollar and smother the pound to dollar exchange rate.
For foreign exchange markets, the next 'big thing' will likely be a significant recalibration in Federal Reserve policy from 'dovish' to 'hawkish'; in other words, accepting that it will be required to raise interest rates.
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The importance of such a regime shift is something Pound Sterling Live reported on as early as mid-month, when winds of change were first detected. That theme is growing stronger following Wednesday's RBNZ guidance.
The euro would also likely feel the pressure:
"We think the hawkish Fed story will be the more dominant theme over the next few weeks and struggle to see EUR/USD sustaining gains over the 1.1650/60 area in the current environment," says Chris Turner, lead FX analyst at ING Bank.
Turner explains that, barring a dramatic collapse in the AI build-out story, "it looks as though we could be moving into a hawkish phase" of Fed discourse.
Thursday should see confirmation that the U.S. inflation picture will require a response. April PCE inflation data is due for release and should show inflation will be moving further away from the Fed's 2.0% target.
"And the build-up to the June FOMC will see increasing focus on the need for the Fed to remove its implicit easing bias," explains Turner, adding:
"We suspect this environment can keep the dollar supported into the June FOMC meeting - although the wild card will be what new Fed Chair Kevin Warsh makes of all of this. We doubt he can sound too dovish too early in his tenure for risk of destabilising the long end of the bond market."
Markets had previously priced a gradual Fed easing cycle through 2026, but the inflationary shock posed by the war in the Middle East prompted the market to shift towards expecting no change in rates.
Inflation data out midmonth showed U.S. inflation accelerated again in April, with headline CPI rising to around 3.8% year-on-year, driven largely by surging energy prices linked to the Iran conflict and disruption through the Strait of Hormuz, which has tightened global oil supply and pushed fuel costs higher.
Core inflation, which is generated domestically, surprised to the upside at 2.8%, confirming it to be truly stuck above the Fed's 2% target and heading in the wrong direction.
"This data only includes the first signs of broader spillover from the oil price shock into core components, and annual inflation is set to move higher in May," says Katherine Judge, an economist at CIBC Capital Markets.
For the dollar, the inflation and linked Fed story is shifting supportive and would put the pound-dollar exchange rate under pressure.
A setback to the 1.3160 lows of April becomes possible under such a scenario where rate differentials move against GBP, particularly if the Bank of England opts to keep rates unchanged as the Fed considered raising rates.
"US rate hike expectations are USD positive because they reflect a resilient US growth backdrop and sticky inflation. In contrast, ECB or BOE rate hike expectations are less supportive for EUR and GBP as they reflect a stagflationary mix of high inflation and weak growth," says Elias Haddad, Global Head of Markets Strategy at Brown Brothers Harriman.
