Why the GBP/USD Rate Could End up at 1.25 Even in the Event of an ‘In’ Vote

Pound sterling has been seen correcting lower having hit overbought conditions over the past few trading sessions but the currency pair could suffer even deeper declines suggests a new analysis.

The pound has pushed higher in decisive fashion as foreign exchange traders continue to erase those declines inflicted on sterling owing to uncertainties posed by the UK’s mid-year referendum on EU membership.

The closing of the gap between where sterling traded due to fear, and where it should be according to economic fundamentals, should ultimately take the GBP/USD exchange rate back to ‘fair value’ levels.

The problem for those hoping for a stronger GBP/USD exchange rate is that this level could in fact be below where the pair currently finds itself.

This suggestion is made based on observations that fair value - as ultimately determined by the economy - is best expressed via interest rate markets.

A strong economy with stable inflation commands higher interest rates than its peers which could be considered to be on a ‘less-stable’ footing.

Thus, one of the most consistent correlations between a currency pair and relative rates in recent years is between GBP/USD and 2-year rate differentials.

Even with the whole Brexit saga this guide has held up relatively well.

And, 2-year sterling rates are now over 20bp below US ones, something which we haven't seen since 2006.

The far right of this chart suggests that while sterling got ahead of itself earlier this year as Brexitmania took off, the pound has bounced too much:

“If you believe that whether the UK stays in the EU or not, rates aren't going to go up even if the Fed finally gets a hike or two out of its system, there's a lot of downside,” says Kit Juckes, an analyst with Societe Generale who has been studying the charts for clues on the GBP’s future direction.

Juckes notes that a 50bp move down in the rate differential would imply a “fair value” for GBP/USD at 1.25.

“That seems implausibly low but still, the only question is how to stay short through the vote - because I'll be even more bearish if the vote is to stay in the EU and sterling bounces,” says Juckes.

So those betting on a stronger GBP against the USD over coming months should keep in mind that any strength in the exchange rate could ultimately prove fleeting.

Latest Pound / US Dollar Exchange Rates

	Live: 1.3347▲ + 0.15% 12 Month Best: 1.3789
*Your Bank's Retail Rate	1.2893 - 1.2946
**Independent Specialist	1.316 - 1.3213 Find out why this is a better rate

* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

Pound is Best Performing Currency in G10 - Why? 

Pound sterling was the only currency to beat the US dollar in the week of 15-19 May.

As mentioned, the closing of that gap between Brexit fear and economic reality is the reason for the move.

Foreign exchange markets are clearly more attuned to the fact that the UK will vote to stay in, and betting markets are confirming this.  

William Hill cut its odds an "In" vote to 1/5, the lowest level to date and indicating an implied probability of 83 percent, a spokesman said.

Betfair odds indicated a 77.5 percent chance of an "In" vote, up from 70 percent last week.

“Political punters suddenly seem to have made their minds up that, contrary to the opinion polls, 'Remain' is a rock solid bet,"  says Graham Sharpe at William Hill.

This view perfectly sums up the views of trades on foreign exchange markets too - sterling has arguably been a far larger and more important bet on the referendum.

Sterling rose sharply over the course of the previous week, shooting up from 1.27 through to highs just above 1.30; the best levels seen since February.

A surge in the value of GBP came mid-week when an Ipsos MORI poll found 55 percent of those surveyed supported staying in the EU while 37 percent wanted to leave and 8 percent were undecided.

Markets will also certainly have taken notice of a reported shift in Conservative voters to Remain; typically these would have been the standard bearers for the Leave campaign.