The British Pound could be considered overvalued argues a new analysis of the currency based on the projected movements in US and UK interest rates.
With the EU referendum behind us, foreign exchange market focus turns towards central banks once more.
With the US Federal Reserve and Bank of England both expected to deliver notable policy changes over the course of the next two months those watching the Pound / Dollar exchange rate should be prepared for notable moves.
There is the distinct chance that should the Bank of England cut rates, and the Fed raise rates, the GBP/USD falls below the post-referendum lows printed at 1.28.
This movement in interest rate policy (one Bank cutting, the other raising) is known as policy divergence and is a major source of movement for currencies.
If you were an investor with large sums of capital, where would you park your money?
In the jurisdiction with the higher interest rates of course. The movement of funds would be expected to bid up the US Dollar at the expense of the British Pound.
In the past, the monetary policies of the Bank of England and the Fed have often tended to be closely aligned, reflecting the strong economic and financial linkages between the UK and the US.
Admittedly, interest rates in the two countries have not always moved in lockstep.
But they have generally headed in the same directiona as can be seen here:
Following the UK’s vote for Brexit, though, investors are now expecting interest rates in the two countries to move in opposite directions.
This will provide the downward force upon GBP/USD, and only once they start moving closer together again, will the exchange rate recover.
The question then becomes just how far this divergence can extend - answering this could potentially answer questions as to how far the Pound Sterling will fall against the Dollar.
“We think that investors are underestimating the extent to which the monetary policies of the Bank of England and the Fed are likely to diverge over the next couple of years, which is a key reason why we forecast that Sterling will fall further against the Dollar during that period,” says Alex Holmes at Capital Economics - the independent economic forecasting consultancy.
Capital Economics therefore think that the contrast in interest rates over coming months will be greater than investors anticipate - the immediate implication is that investors could be potentially overvaluing the Pound against the US Dollar as a result.
Capital Economics believe that the MPC will cut the Bank Rate by 25bp at the August 4th meeting while adding £75bn to the quantitative easing programme.
However, where Capital Economics diverge from consensus is on Fed policy changes.
“We disagree that the Fed will only tighten policy very slowly. Our view is that it will hike again as soon as September and by much more next year than investors assume,” says Holmes.
This feeds into Capital Economics’ forecast for Sterling to fall further against the Dollar in 2017, reaching $1.20/£ from around $1.32/£ now.
Looking further ahead, analysts warn that investors have gone too far in reassessing the outlook for monetary policy in the UK over the medium to long term.
Capital Economics hold the view that Brexit will do little long-term damage to the UK economy.
Indeed, markets are now expecting Bank Rate to be as low in five years’ time as it is today - this is far too pessimistic it is argued.
Therefore, the recovery over subsequent years could be faster and more aggressive than markets are presently pricing.
“We don’t see why monetary policy should remain a lot looser in the UK than in the US for longer than that, simply as a result of Brexit,” says Holmes.
US Federal Reserve Looks to One Rate Hike in 2017
The US Federal Reserve's Open Market Committee statement released on July 27th proved to be no game-changer for those watching the US Dollar based on US interest rate expectations.
While the Fed said that it continues to closely monitor global and financial developments (same as in June), it did upgrade its assessments of the economy and the labour market.
It now suggests that risks have diminished which is a new and significant addition.
"The takeaway is that the Fed is clearly eying higher rates this year. The dollar reacted positively initially, but the move was quickly corrected and the dollar weakened as the FOMC refrained from sending any clear signals of a September hike," says Erica Blomgren at SEB.
Treasury yields and the Dollar dropped while the S&P 500 erased earlier losses ending the day -0.1%.