GBP/USD: Dollar Jumps on Fed's Neutral Stance

The pound US dollar exchange rate slipped from session highs on Wednesday following the Federal Reserve policy announcement. The pair dropped from a high of US$1.3100 to close at US$1.3054. The pair was trading flat in early trade on Thursday.

The pound traded higher versus its major peers on Wednesday. Pound traders shrugged off data that showed that growth in the UK manufacturing sector slowed in April. The manufacturing pmi dropped to 53.1, in line with analysts’ expectations but down from 55.1 in March. The decline comes as companies eased back on stockpiling as Brexit was pushed back until October. New orders also slowed, particularly from Europe US and China. Usually weaker data would pull the pound lower. However, Brexit optimism was keeping demand for the pound strong.

Hopes are building that cross party talks between the government and the opposition party are progressing. The UK Prime Minister Theresa May hinted in question time that she could accept a compromise over a customs union in order for the talks to progress. This would result in a softer version of Brexit, but a Brexit deal nonetheless. The pound is rallying on optimism that the two sides can push an agreement over the line possibly in the coming weeks.

Why is a “soft” Brexit better for sterling than a “hard” Brexit?
A soft Brexit implies anything less than UK’s complete withdrawal from the EU. For example, it could mean the UK retains some form of membership to the European Union single market in exchange for some free movement of people, i.e. immigration. This is considered more positive than a “hard” Brexit, which is a full severance from the EU. The reason “soft” is considered more pound-friendly is because the economic impact would be lower. If there is less negative impact on the economy, foreign investors will continue to invest in the UK. As investment requires local currency, this increased demand for the pound then boosts its value.

Today the Bank of England (BoE) will give its policy announcement. Analysts are not expecting any changes to monetary policy. Even though the Brexit deadline has been extended to October, UK economic growth is expected to remain subdued as Brexit uncertainties linger. As a result, the BoE is still cornered over Brexit.

Fed Gives Dollar A Boost

The Fed kept interest rates on hold as analysts expected. However Fed Chair Jerome Powell also dampened prospects of a rate cut by the central bank before the year was out. Powell said that the recent soft inflation was likely due to transitory factors and stuck to his neutral stance.

The markets had been assuming a 65% chance of a rate cut this year, prior to the Fed meeting. This has since dropped to 50%. As dollar investors digest the Fed’s rejection of a rate cut, the dollar moved higher.

Why do raised interest rates boost a currency’s value?
Interest rates are key to understanding exchange rate movements. Those who have large sums of money to invest want the highest return on their investments. Higher interest rate environments tend to offer higher yields. So, if the interest rate or at least the interest rate expectation of a country is relatively higher compared to another, then it attracts more foreign capital investment. Large corporations and investors need local currency to invest. More local currency used then boosts the demand of that currency, pushing the value higher.

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