British Pound US Dollar Exchange Rate Forecast

A close examination of the wave structure from the January 2009 low reveals that the larger trend most likely remains down. Specifically, the rally from 13500 is a 3 wave correction and the decline from 17050 is in 5 waves. The advance off of the May low has met the 61.8% retracement, which would be an ideal area for a top to form. Additional strength would test 16465.

British Pound / US Dollar Interest Rate Forecast

The British Pound/US Dollar currency pair has also traded in line with the spread between U.S. and U.K. yield expectations. Again the main driver has been the declining outlook for Fed tightening which has shifted the balance in the pound’s favor. Overnight index swaps are pricing in 29 bps of tightening from the BoE which is nearly identical to what we saw in June. However, inflation over their 3.0% threshold and Governor King stating that rate hike would be the first step in removing stimulus has markets starting to bet the MPC will be the first to raise rates.

Policy makers outside of Andrew Sentence have held the view that consumer prices will return to target levels allowing them to take a measured approach in determining future direction. The central bank still hasn’t taken additional stimulus off the table and if they maintain their dovish stance we could see the sterling weighed.

British Pound / US Dollar Valuation Forecast

GBPUSD Valuation Forecast: Neutral

Sterling has bounced back into overvalued territory – trading at an 8.9 percent premium to its PPP-implied fair exchange rate – after the new coalition government introduced an ambitious austerity budget to put UK’s fiscal house in order. The outlook going forward is deeply uncertain however, with traders not clear on what the plan will mean for the nation’s nascent economic recovery, particularly vis-à-vis monetary policy. Indeed, government spending as played a central part in the return to GDP growth, and a sharp reduction here coupled with the weight of higher taxes on private consumption may mean that the BOE (at least) remains at the current, highly accommodative setting for the foreseeable future. Consensus economic growth forecasts compiled by Bloomberg suggest that US growth will outpace the UK by an average of 1.13 percent through 2012, hinting the Fed will likely move to tighten faster than their British counterparts and promising to send GBPUSD lower. In the near term, however, the lack of clarity in the UK landscape leaves a lot of room for speculative interpretation and knee-jerk price action, suggesting it is prudent to remain on the sidelines for now.

What is Purchasing Power Parity?

One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.