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Foreign Exchange

Sterling is sideshow relative to dollar and euro, says HSBC

Sterling is, and will probably remain, a sideshow to other currencies because the market is fixated with the risks to the euro and the US dollar, according to research published by HSBC, making it a less attractive currency to trade on a momentum basis, traders say.

HSBC conducted an analysis using its so-called diffusion index, which measures the breadth of sterling’s movements against 14 currencies and the number that are rising and falling against it, based on a 20-day moving average. The results of the analysis show that periods of strength or weakness in the sterling have tended to last for only short periods, meaning that the currency has been basically rising and falling equally against the broad range of currencies.

Indeed, HSBC adds that the last time the market really focused on trading the pound was during the UK general election last year. For the market to start trading it again, there would need to be a “significant” change in the outlook for the UK economy, concludes David Bloom, HSBC chief foreign-exchange strategist. The pound’s value is being dominated by the dynamics of other currencies, rather than trading its own fundamentals.

Sterling is caught in the crossfire between negative developments surrounding the euro and the US dollar, he says. When eurozone sovereign risk dominates market focus, the pound underperforms the dollar, but outperforms the euro. In such instances, sterling is dragged lower because it is caught in the “euro’s orbit” due to its trade links within the EU.

Conversely, when the market became bearish on the dollar, and European sovereign risk was less of a focus, the pound underperformed against the euro, and slightly outperformed against the dollar.

In the meantime, HSBC maintains a bearish outlook on the UK economy because it believes the current fiscal tightening could turn into a slowdown. “Although we maintain a relatively pessimistic view on the UK economy, it will also be the misfortunes of other currencies that will keep GBP trapped in the ‘ugly contest’,” Bloom writes in a report published on July 15.

For the pound to become a major focus again, the UK’s macro picture would have to substantially strengthen or worsen, Bloom argues. All that is happening at the moment is a slow deterioration, with GDP growth consistently falling below expectations and inflation consistently higher.

The market has appeared to give the pound a slight advantage over the dollar owing to the UK’s more credible deficit-reduction programme, Bloom suggests, helped by a belief that the Bank of England could raise rates before the US Federal Reserve. Such a belief now looks unjustified, with real wage growth remaining negative in the UK.

Expectations of a BoE rate rise are no longer being priced in via the rate swap market, Bloom says, though the pound has yet to fall back accordingly. Bloom pins sterling's failure to fall against the dollar on the breakdown of the relationship between interest-rate differentials and sterling price action following the financial crisis. If the relationship still held, then the pound should be closer to $1.55, Bloom notes. He cites this as evidence that dollar-negative dynamics have dominated trading more than the negative headwinds for the pound, trumping rate differentials.

The best scenario for sterling would be a successful UK deleveraging and a sustained recovery. Under this scenario, the pound could easily trade at 1.75 or above against the USD, Bloom says.

The opposite scenario is the one that seems to be playing out at present, however, he concludes: a fiscal tightening turning into a slowdown. “In this situation, the UK is the example of how not to do things. Here GBP-USD could easily trade at 1.45.

“In the absence of either of these scenarios playing out, fair value is between 1.55 and 1.65, and there is little reason GBPUSD should break out on either sides of this range.”

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