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The pound to dollar exchange rate risks near-term losses, but weakness should be contained.
Currency markets have sold the dollar ahead of a crucial midweek decision that should result in a rate cut, but we are wary of a potential rebound following the decision.
The Fed will shave 25 basis points off the Funds rate, with markets anticipating a further 50 to be knocked off by year-end as the Fed fights to shore up the USA's weakening jobs market.
This ample easing in monetary conditions should weigh on short-term U.S. bond yields and is why the dollar has been positioned lower, allowing the euro to run to a new four-year high in the lead-up to Wednesday's decision.
The pound, by contrast, is underperforming its European counterpart in the ascent against the dollar, but is nevertheless already up 0.63% this week at 1.3642 and eyeing the 2025 peak at 1.3784 as the net port of call.
But for both EUR/USD and GBP/USD, near-term risks see a USD comeback in the wake of the decision itself, with some in the market saying it is worth anticipating a 'sell the fact' market response.
"Significant easing is already priced in, and the bar for a dovish surprise from the central bank is high. This creates the case for a buy-the-rumour-sell-the-fact reaction," says Dr. Luca Cazzulani, Head of Strategy at UniCredit in Milan.
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"A lot of dovishness is already priced into a weaker currency. The USD consolidation this morning could signal that 'enough is enough,' says Daragh Maher, Senior FX Strategist at HSBC.
"The USD would also capitalise were the dots to signal only one cut is likely in Q4 25, or if Powell were to signal that the Fed is cautious about the easing pace given upside risks to inflation," he adds.
Although a U.S. Dollar rebound is now possible, the prospect of an enduring recovery is limited and strength will likely be sold into as future rate reductions diminish the support U.S. yields have offered the U.S. dollar for so long.
More broadly, ongoing demand for USD hedges by foreign investors and concerns about the indepdence of the Fed in the face of President Donald Trump's efforts to influence policy will add to USD headwinds.
Owing to the triple headwinds posed by falling rates, politics and hedging, the USD downtrend is firmly intact. This means any episodes of pound-dollar weakness should be viewed as temporary, allowing for a steady run higher over the coming weeks.
"For GBP/USD, we see the bearish dollar story dominating from October onwards and GBP/USD ending the year towards the top of the 1.32-38 range. We're cognisant of the big event risk around the 26 November UK budget, but expect the cleaner dollar bear trend to be the dominant factor at this point," says Chris Turner, head of FX analysis at ING Bank.
Idiosyncratic risks for GBP could emerge ahead of the November budget; faced with a burgeoning budget deficit, the Chancellor must raise taxes again, which risks perpetuating an economic doom-loop.
A loss of credibility could precipitate a bond market rout that could seriously undermine GBP and open the door to a USD recovery.
We can't say whether this will happen for sure, but it is certainly the ‘black swan’ risk event for Sterling into year-end.