On Friday, the UK will release some key data that is likely to disappoint cable bulls. The currency pair has been declining for months at this point, with the trend accelerating recently. Is it possible there will be a turn around at some point? And what data could give us an indication that the downward trend could come to an end? Or should traders keep their hands on the sell button?
The UK will publish its final reading of Q2 GDP on Friday, which is normally a quiet event. That’s because the final number often is the same as the initial number, so nothing much changes for the markets. But, in light of what the BOE did last week, it opens the discussion for what could happen with the pound going forward.
There is no more room
The BOE said it was essentially done with hiking, largely because the economy wouldn’t allow for more tightening. As interest rates go up, the economy is expected to slow. With the UK economy barely staying afloat, further tightening would likely cause a recession. At least in the estimation of the BOE.
The price of the dollar-pound pair is influenced primarily by the differential interest rates. Meaning, how much money investors can expect to receive if they buy dollar debt as opposed to pound debt. In the US, the interest rate is above the inflation rate, meaning that investors in America will get a real net profit in dollars. Investors in the UK will get a real net loss, because the interest rate is below the inflation rate.
Follow the money
Although that situation might change if BOE Governor Andrew Bailey is right about inflation coming down, at least for now it’s worthwhile to sell pounds to buy dollars. That will naturally push cable down.
Especially if we consider that the Fed says it will raise rates once more this year, while the BOE will not. That will simply exacerbate the profitability of buying dollars and selling pounds. The Fed can keep hiking to bring down inflation because the US economy is still growing. In fact, the Fed itself estimates that the current quarter will see an annualized growth of 4.1%. Compared to the UK, where annualized growth for this quarter is expected to be just 0.8%.
It’s now all about the economy
If the UK tips over into a recession, then that might bring down inflation. Initially, that might be good for the pound; but it also would put pressure on the BOE to cut rates. The market is pricing in a higher chance that the BOE will cut sooner and more than the Fed. That means holding UK debt going forward will be less profitable than holding US debt, which means more selling pressure on the pound to buy the dollar.
Of course, if the UK manages to scrape through without a recession, then the decline in the pound can be halted. This means traders should pay close attention to signs of economic activity, such as PMIs, job numbers, and retail sales. The flip side is also possible: That the US enters a recession, forcing the Fed to cut rates. A market crash inspired by a Moody’s downgrade of US debt if a government shutdown happens, could precipitate such a situation. But, that’s betting on an uncertain event. For now, the forces seemed to be aligned against the cable bulls.
