Sep 28, 2022 7:34 PM +05:00
VOT Research Desk
British Pound Rundown
In the beginning of September, GBP/USD was in a difficult position, and the issue has continued to worsen.
The British pound and the UK are experiencing a negative feedback loop, with a falling currency leading to rising bond yields and the Bank of England’s intervention effort resulting in further currency collapse. An agonizing feedback loop that has not yet come to an end.
Is there any reason to be hopeful? And given that it resembles issues that can be found in both Europe and the United States, is this a problem that will be confined to the United Kingdom?
The British pound collapsed last week, or so we thought, only to open our platforms this week to see what a collapse in a major currency actually looked like. The current backdrop is messy, with bonds and foreign exchange screaming panic and US equities looking relatively calm.GBP/USD has fallen to a new all-time low, and perhaps even more troubling, the price has not really recovered much in the days since. Sellers are still hitting the pair, and additional dislocations are occurring.
Extreme inflation is a problem that the UK, like Europe and the United States, faces. Throughout the majority of the previous year, all three central banks maintained a relatively calm atmosphere as inflation increased. However, this year, as inflation continued to rise despite initial tightening efforts, concern began to emerge due to the fact that central bank efforts were not only unsuccessful but also appeared to bring about additional issues.
Additionally, a very logical issue is currently in progress. It’s like putting the sword of Damocles over the bond market as central banks warn of much more tightening ahead. Prices fall when rates rise. Additionally, portfolios are marked to market and prices fall, resulting in unrealized losses that are unappealing. Therefore, if participants in the bond market are aware that a central bank is going to launch a severe campaign of tightening, they are certain that the central bank will be working against their existing positions, which gives them a lot of reason to sell.
Rates go up as a result of selling bonds. This was known because central banks were doing quantitative easing (QE), but QE became so common that the risks seemed to be gone. We are now witnessing the consequences of that, and they are not restricted to the United Kingdom only.
Since a weaker domestic currency automatically makes imported goods more expensive, the GBP/USD’s start to fall last week raised the possibility of even higher inflation in the future. It is yet another significant obstacle preventing the UK economy from recovering.
The collapse of GBP/USD this week and the subsequent all-time low in the US dollar made Friday’s sell-off appear rather insignificant. However, the bond market and market participants holding a lot of bonds (like pensions) are under even more pressure as a result of this raising the possibility of even stronger inflation, which will require even more rate hikes to contain. Additionally, this encourages additional bond sales, which results in even higher yields.
The UK gilt market this morning was explained by this. Additionally, there was a growing rumor that significant market participants may be in significant pain, necessitating forced sales that could have negative repercussions elsewhere.
In an effort to slow the rapid rise in British bond yields, the Bank of England decided to intervene this morning. Because the BoE will likely need to print GBP in order to buy bonds on the open market, which is a similar process to QE, this is a very counterintuitive strategy. Buying bonds on the open market could help keep yields low, but it also means that the central bank will print more GBP to buy bonds.
All things being equal, this means that there will be more inflationary pressure because more GBP could be available, which could result in a lower spot price. And all of this is taking place at the same time that the central bank is trying to raise interest rates to stop inflation. It seems like the Bank of England is now in a situation where they have to deal with both sides: raising interest rates and printing money.
It may seem obvious that this is unsustainable, but it is an emergency measure taken to stop a growing problem. Unfortunately, due to the fact that it brings up additional issues, it is difficult to imagine that this will be the final solution to that issue. In addition, the United Kingdom is not the only economy in a similar predicament that faces extreme inflation and an economy that appears unable to withstand the tighter monetary policy that will be required to bring that inflation under control.
GBP/USD This seems to be the weakest point right now, and the big question is whether there will be another wave of selling that could actually bring the pair down to the psychological level of parity.
The news this morning sparked a very bearish reaction, with the GBP/USD pair losing 300 pips following the QE announcement. However, the price remained above a significant support area around 1.0500/1.0520, which was the previous GBP/USD pair all-time low. This week, prices briefly tested that area, but there was not a significant amount of time spent there. This is support until it is removed, and if sellers remove it, it could be interpreted as a very bearish signal.
Since the spill this morning, there has been some recovery, and price action is working back into the range that formed after the collapse-like move. There is still resistance around 1.0828, and the range’s middle point is around 1.0737.
If we take a step back, we can give some context to the recent volatility. Naturally, price action has been a mess down here, but the main thing for me to take away is that there hasn’t been a bigger recovery yet and that the BoE has brought back QE.
After the new all-time low at 1.0350 is reached, a test of a swing low at 1.0445 opens the door for a break of the 1.0500/1.0520 area.
Since the snow below that is brand-new and has never been touched, I typically choose psychological levels for support/resistance readings. Naturally, the parity level stands out, but if that level is present, it becomes a problem in and of itself, as was the case with EUR/USD in March 2015.
Positively, a break of that resistance at 1.0828 opens the door for a move up to 1.0931, after which the psychological comes into play, and I would anticipate that this would require some assistance from an economy outside of the UK. That would be significant to me because there is probably still a significant short position in the situation and a decline to 1.1000 would indicate a greater likelihood of recovery.
