The pound has had a bad start to 2015 and is the second worst performer in the G10 behind Norway, which is getting a thrashing as the oil price continues to crash. So why is the FX market turning on the pound? After all, our currency was one of the better performers vs. the USD last year.
Four things are taking a toll on sterling:
1, Weak economic data: the latest disappointment was weaker than expected PMI data for December; the composite survey for last month fell to its lowest level since May 2013, suggesting that the economy truly has come off the boil.
2, The oil price decline: this is bad news for the FTSE 100 as energy companies make up a sizable 14.5% of the index. It is also keeping Gilt yields low as the falling oil price is likely to weigh on the UK’s CPI rate in the first few months of the year. Thus, a falling oil price is bad news for some UK equities and for the pound.
3, Politics: This is a theme that could plague the pound for the rest of the year. Already the prospect of a hung parliament, the first since the 1970’s, is starting to spook investors. This is expected to be a tight election, combined with the prospect of an early EU referendum if the Tories win power, the pound cold stay volatile for some time.
4, The interest rate differential: the UK and US rate spread remains mired in negative territory, and the 2-year yield spread has fallen to its lowest level since 2006. The 10-year yield spread has a closer relationship with GBPUSD, and that is also at a 9-year low.
Why rate differentials matter:
The economic and political factors weighing on the pound are fairly straight forward to understand, however the rate differential could be the most important factor for GBPUSD this year, even more important that the May elections.
Interest rates determine how much you earn from holding a particular currency. When rates are falling in the UK you earn less holding pounds than you do another currency such as the US dollar, where rates are not falling at such a fast pace.
Read any book on FX and you will hear how important central banks are to FX. Right now the market believes that the Bank of England will delay hiking interest rates, while the Federal Reserve could hike rates in the first half of this year. This means that the market thinks that the pound will earn less than the dollar for some time, which is a potent factor weighing on GBP right now.
A silver lining?
It looks like it could be the perfect storm for the pound right now, however, with the UK-US yield spread at 9-year lows, and GBPUSD falling so precipitously, could it be time to turn against the tide of GBP selling?
The biggest risk to the yield differential could be a reversal. US 10-year yields have already fallen below 2% for the first time since October, and as my colleague Matt Weller wrote there are some dovish members coming onto the Federal Reserve this year. If they sound concerned about rate hikes then we could see expectations for a US rate hike get pushed back, weighing on 10-year Treasury yields and the dollar.
The technical picture:
For now, we would warn against a near term GBPUSD reversal, but further downside could be limited to another 300 pips. 1.4814 is likely to act as a major level of support, it is the low from 7th August 2013, and is also the 100% retracement of the entire 2013-2014 advance.
We could see some taking profit as we approach this key level, but until then the downside could resume as long as we remain below 1.5341 – the intraday high from Monday. Short term supports include: 1.5176 – the low from 5th Jan, and then 1.5102.
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