Above: File image of Federal Reserve Chairman Jerome Powell. Image © Federal Reserve.
The pound rises against the dollar, but relief could be short-lived.
Pound sterling put in a strong recovery overnight and is building on those gains in midweek European trade, courtesy of confirmation by the Federal Reserve Chair that further interest rate cuts are coming.
Jerome Powell said in a speech given to the NABE Annual Meeting, "this policy stance, which I see as still modestly restrictive, leaves us well positioned to respond to potential economic developments."
'Restrictive policy' is shorthand for interest rates that are high enough to restrict the economy to the extent it limits inflation. In this context, Powell is saying the Fed has ample room to cut interest rates without risking stimulating inflation.
Powell said that weakness in the labour market is outweighing concerns about stubborn inflation.
Given his concerns that U.S. employment indicators are heading in the wrong direction, the inference is that the Fed can cut interest rates again to help employers while not risking pushing inflation higher.
A rally in stocks and a fall in the dollar confirm this interpretation was adopted by traders.
"The dollar has weakened after the Fed’s Jerome Powell said that concerns about a weakening labour market justifies interest rate cuts. A rate cut later this month is now fully expected," says Kathleen Brooks, research director at XTB.
Also, Powell said the Fed might decide to stop shrinking its balance sheet in the coming months, which is another pro-stimulus measure that would naturally weigh on the dollar.
The OIS forward curve - a money market price indicator that tells us what traders think interest rates will do - is pricing in two 25 basis point rate cuts by the end of this year.
The market looks to have been a little unsure as to what the Fed was thinking, and it has taken heart from Powell's latest comments.
The pound to dollar exchange rate (GBP/USD) recovered to 1.3315 in the wake of Powell's comments, up from 1.3248, a low that was plumbed amidst a risk-off mood in global markets owing to rising China and U.S. trade tensions.
That low was also inspired by a softer than expected UK labour market print, which opens the door to another interest rate cut before year-end at the Bank of England.
Although there's been a recovery, a lot more work needs to be done to overturn a technical downtrend that is underway.
Above: GBP/USD with our Week Ahead Forecast annotations drawn on Monday.
"GBPUSD is heading towards 1.3140, the 61.8% area of growth from the lows at the beginning of the year to the peaks at the start of July. This level stopped the pair's correction in July, maintaining its growth pattern. Just above, at 1.3180, is the 200-day moving average," he explains.
The charts advocate for further weakness, but the fundamentals now hint that a bottom could be in sight.
This is because the outlook for Federal Reserve interest rates is a powerful determinant of where the dollar will go, and therefore will determine the GBP/USD's ultimate fate.
If the China-U.S. trade situation calms and market nerves settle, investors will be inclined to focus more on Federal Reserve policy where more rate are coming, potentially meaning GBP/USD can benefit from the ensuing pullback in the USD.
Nigel Green, CEO of deVere Group, reckons Powell has to get a move on. He says the Fed Chair's record is defined by hesitation at key turning points.
"In 2018, the Fed tightened too long and too hard, only to reverse course months later when markets sold off," he explains. "In 2021, officials underestimated inflation for nearly a year before being forced into the most aggressive rate-hiking cycle in decades."
"The same pattern is seemingly repeating on the way down. Powell waits until the evidence is overwhelming, and by then the economy has already slowed," says Green.