GBP/USD Forecast: Risk Reversal Studies and Spreads Divergence Argue for More Gains for Exchange Rate

We anticipate Pound Sterling to extend recent gains against the US Dollar in coming days but are conscious of the volatility posed by Tuesday's US election.

• Further upside gains for GBP/USD are possible as the divergence between cable’s current spot levels and those implied by interest rate differentials is particularly large.
• Risk reversals are recovering, suggesting that the market could be shifting towards a less bearish stance

It is too early to call the end of the Dollar's rally we are told.

Analyst Kathleen Brooks at City Index has confirmed options markets continue to price in a GBP recovery with risk reversals hinting at a trading community that is increasingly anticipating a bounce.

Risk reversals in the FX market measures the difference in volatility between call and put options.

"There has been a positive rise in the risk reversal for GBPUSD across time frames in recent days, this means that the volatility of calls has risen at a faster pace than the volatility of puts, which suggests that the market is betting on a currency rise, or in the case of the pound, a recovery," says Brooks.

Brooks says that while GBPUSD risk reversals are still in negative territory they have recovered across the curve since last Thursday, after reaching a low in mid-October.

Risk reversals have largely improved over the six-month timeframe as more in the market now don't see Article 50 being triggered within that time following last week's High Court ruling.

"The fact that the risk reversal at this time frame is recovering suggests that the market could be shifting towards a less bearish stance towards the pound on the back of a delay to the UK leaving the EU, and potentially a softer Brexit than what the market thought last month," says Brooks.

Latest Pound / US Dollar Exchange Rates

	Live: 1.3342▲ + 0.12% 12 Month Best: 1.3789
*Your Bank's Retail Rate	1.2889 - 1.2942
**Independent Specialist	1.3155 - 1.3209 Find out why this is a better rate

* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

The charts are also more bullish.

Analyst Eric Theoret at the Bank of Nova Scotia says he thinks the GBP could recover a little more ground near-term.

“GBPUSD short-term technicals: positive - GBPUSD has made some clear and notable technical progress this week, clearing resistance in the low 1.23 area, trend resistance off the June high. That suggests scope for the GBP to extend towards 1.25/1.26 potentially,” says Theoret.

On the domestic scene the Pound’s resilience will largely depend on the trajectory of the Brexit story.

Prime Minister May wants to press ahead with Article 50 declaration early next year and speculation persists that an early election may be one way of clearing parliamentary opposition.

The Article 50 ruling of the previous week has opened up the prospect of protracted uncertainty and Sterling’s recovery is by no means guaranteed with more twists and turns in this saga expected.

TD Securities: Year-End Forecast for 1.20 now in Doubt

Following the recent recovery in Sterling we hear that analysts at TD Securities are preparing for the Pound to overshoot their year-end projections against the Dollar.

“On a more strategic basis the now-sustained break of resistance around 1.2325 puts our end-Q4 forecast of 1.20 into doubt,” says James Rossiter at TD Securities.

Rossiter believes further upside gains for GBP/USD are possible as the divergence between cable’s current spot levels and those implied by interest rate differentials is particularly large.

This is true not only in absolute terms but also when compared to the rest of the G10 complex.

“Based on rate differentials alone, admittedly a heroic assumption in this context, GBP/USD should be trading closer to 1.36,” says Rossiter.

TD Securities do however continue to believe that fundamentals will drag GBPUSD lower over the medium term.

“Still, this may now take longer to achieve as the market’s large overhang of existing shorts looks likely to be reduced. We will need to see how events from here evolve, but we see notable upside near-term risks,” says Rossiter.

At this stage, and in the absence of a majors surprise that refocuses our attention on downside risks, Rossiter says he would not be too surprised if we closed 2016 in the low-to-mid 1.20s.

TD Securities affirm their Q1-2017 target of 1.17, however, as they think these downside risks are likely to materialise before too long.

US Election: Potential Reactions

The US Dollar gapped higher at the start of the week on news that the FBI sent a letter to Congress saying that Hilary Clinton hadn’t committed a crime by emailing using private servers.

The result of the news has been a rapid re-pricing by financial markets of a Clinton victory in Tuesday's vote.

Clinton is seen as a continuity candidate and her ascent to the throne will surely allow the US Federal Reserve to press the button an interest rate at their December meeting.

Expectations of higher rates are the ultimate guarantor of a stronger USD.

“All of the attention this week was already going to be on the US election. But volatility from the event risk has come earlier than the market had thought it would on news the FBI found nothing concerning in its investigation of this latest batch of Clinton emails,” say analysts at LMAX Exchange in a client briefing.

Despite the latest development it must be remembered that Trump and Clinton remain neck-in-neck in the polls and the outcome is by no means assured. Expect further volatility.

"An element of uncertainty remains over this election. It seems unlikely that markets will make a full 'risk on' move until Clinton is declared the winner," says Ric Spooner at CMC Markets.

GBP/USD trades at 1.2404 at the time of writing having opened this week's account at 1.2487.

Pound Sterling traded to its best levels since October 7th over the course of the previous week as a combination of broad-based US Dollar weakness combined with improving sentiment towards the UK currency.

Much of that Dollar weakness came on news that Trump had closed the gap on Clinton in the polls.

Sterling has benefitted from the US Dollar’s woes stemming from Donald Trump’s sudden surge in the polls which has unsettled investors who now have to price uncertainty into the Greenback.

The relative policy mix between the two candidates is wider this time around than in previous elections and therefore the need to price uncertainty is understandable.

To make matters all the more difficult for traders, as we note here, the dynamic whereby a Trump victory = a weaker US Dollar is not set in stone, and Trump could actually benefit the Dollar longer-term.

How markets react to the results is therefore quite hard to gauge but for now it appears that a Trump victory will likely trigger a negative USD reaction.

America goes to the polls on the 8th November and, “if this week is any indication, the culmination of the US elections and uncertainty over who the next President might be could prove to be beneficial for the Pound in the immediate future,” says Paresh Davdra at RationalFX.

We will be watching the release of election results for volatility - it is hard to say what either a Clinton or Trump victory mean for GBP/USD at this stage so we would urge caution on all FX pairs around this time.

“The polls continue to tighten and we see the risk that following payrolls market liquidity dries up, as market participants await for Tuesday’s election results. Reduced liquidity is likely to inject greater dispersion in the price action,” says Mark McCormick at TD Securities.