It wasn’t so long ago when the Fed signalled a wind down in asset purchases was on the horizon, and the BoE could only hope to shift towards more normal monetary policy. How times have changed, and although the Fed has managed to begin tapering, the delay and minimal monthly reduction has resulted in a reduced effect on the GBPUSD rate.
The UK made a surprisingly strong recovery in the second half of last year, and in particular the improvement in the labour market has spurred speculation about when the BoE will bite the gun and raise interest rates. Both economies are on the right track, however the last two non-farm payrolls figures have been disappointing and raised questions about whether the Fed could continue to cut back purchases by $10bn every month.
In her first testimony to the House Financial Services Committee, Fed Chair Janet Yellen acknowledged the development being made in the US economy, but also highlighted that there was still more work to be done and it is important to consider more than just the unemployment rate when “evaluating the condition of the US labour market". In the latest BoE Inflation Report, Governor Carney expressed a similar viewpoint, and despite raising growth forecasts, emphasized that the amount of slack in the economy is a big issue and other broader indicators will be needed to evaluate the economy’s progress. Forward guidance from both the Fed and BoE has indicated that rates will be held constant even after the unemployment thresholds have been breached.
The key difference in policy which may alter the performance of cable (GBPUSD) over the coming year will be the Fed’s decision to taper and hold rates vs the BoE’s decision to raise rates before cutting back on asset purchases. Initially, tapering was expected to have a larger effect on the strength of the dollar as the market viewed it as a tightening of policy. Ever since the UK economy picked up, and forward guidance created a benchmark to gauge the likelihood of rate hikes, the interest rate hawks have been fuelling a stronger pound. The prospect of a rate increase may be far more tempting than continued tapering, especially at a pace of $10bn per month. Although both central banks are trying to convince the markets that policy will remain accommodative, the Fed seems to have succeeded, whilst BoE has failed so far. The fact that the BoE’s initial projections for unemployment were badly timed has had a large effect on the credibility of its forecasts. This has allowed the market to go with its own estimates and continue to price in a rate increase in Q2 2015.
As long as UK growth continues to outperform, the possibility of a rate hike will increase limiting the dollar's potential. Disappointing US data will hurt the greenback, and with the market regarding Yellen as a dove, we doubt investors will hesitate to weaken the dollar further.
Sasha Nugent
Currency Analyst
