The European Central Bank And The Bank Of England Face An Urgent Need To Continue To Tighten Policy Because Inflation Remains Strong

Pound Sterling: Short-Term Repricing Complete, But Further Uncertainty Looms

The foreign exchange market is expected to move quite sharply in 2023 as two mutually directed processes - fighting inflation and trying to slow or prevent the onset of recession in each of the currency zones - follow similar scenarios, but in different conditions.

Let's look at the balance of short and long positions in speculative positioning in the long-term, based on CFTC reports. To clearly see how large speculators build their strategy, let's consider the ratio of long and short positions for each of the currencies against the U.S. dollar. We will convert the long and short volumes for each of the currencies using a simple formula: divide the difference between long and short positions by the sum of long and short positions and normalize them between -100 and +100. We will sum up the result in the table.

Exchange Rates 30.12.2022 analysis

The interpretation of the results is as follows. If the line is above zero, the positioning is bullish, if it is below then it's bearish. The direction of the line whether it's up or down shows the dynamics of the speculators' sentiment over time.

As follows from the table, the euro shows the most stable and consistent growth in regards to sentiment. The bullish bias is evident, i.e. long-term expectations on the futures market are in favor of the euro, which suggests that EURUSD will continue to rise during the first weeks of the new year.

The New Zealand dollar unexpectedly took second place. The positioning was bearish for a long period, but in the last week a sharp growth of longs and a decline in shorts became evident. This means that the market sees the prospect of the kiwi strengthening against the current levels, the long-term target might be in the resistance area at 0.6680/6720.

All other currencies are still in the bearish area (below zero) and are quite close to each other. Nevertheless, the movement in favor of growth in longs and a decline in shorts (upward direction of the lines) is noticeable for all currencies, except for the Canadian dollar. This synchronism allows us to conclude that the foreign exchange market is focused on a scenario of a gradual transition of demand from the dollar to other currencies.

Sentiment is determined by a number of factors, and the most important one is inflation expectations in each of the currency areas. As the chart below clearly shows, the spread between the Federal Reserve's discount rate and inflation has been growing most steadily for the dollar since August, which means that the US central bank has been the most consistent among all major central banks in stopping the inflation surge and achieving a noticeable result.

Exchange Rates 30.12.2022 analysis

And if so, then the market sees the Fed's policy as not only the end of the rate growth cycle, but also a reversal to its decline earlier than the other currencies, that is, long-term expectations for the yield spread suggest a fall in the dollar's position.

But the European Central Bank and the Bank of England face an urgent need to continue to tighten policy because the actions they have taken by the end of 2022 did not produce a noticeable result. Inflation remains strong, and as the winter progresses, as sharply higher energy rates begin to factor in, inflation will remain high, real yields will be much lower than in other countries, and they will be forced to continue policy tightening longer than the Fed forecast. This means that in dynamics, long-term yield spread expectations will shift in favor of the euro and the pound.

For the euro, we just see a steady bullish repositioning (see the first chart), the pound lags behind, but the projections for the BoE's actions are firmly bullish. Forecasts for the ECB and the BoE's further actions are hawkish, and unlike the Fed, the end of the tightening cycle and a pivot to monetary policy easing are seen much further into the future, meaning that over the long term, the yield spread will start to grow in their favor.

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We expect both currency pairs, EURUSD and GBPUSD, to resume growth in the first weeks of the new year. Long-term targets for EURUSD are 1.0940 and 1.1270, for GBPUSD we can expect attempts to rise to the area of 1.2750/60.

It is necessary to take note that the Bank of Canada is likely to strengthen its hawkish stance since its efforts haven't produced any noticeable result yet. And also the Bank of Japan, as the dynamics of yield on the yen remains negative, which puts the yen in a losing position in the long term due to the risk of increased capital outflow from the country.

As for the Australian dollar, there is no clarity yet. The dynamics in the futures market is minimal, the Reserve Bank of Australia is behaving very cautiously and does not allow the aussie to deviate either to one or the other side of the market trends.

The U.S. dollar, according to the CFTC reports, is close to exhausting its growth potential, the Fed's role as a flagship is nearing its end. The dollar stands a good chance of continuing to weaken across the currency market spectrum in the first weeks of 2023.

 

 

Relevance up to 07:00 UTC+1 Company does not offer investment advice and the analysis performed does not guarantee results. The market analysis posted here is meant to increase your awareness, but not to give instructions to make a trade.

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Pound Sterling: Short-Term Repricing Complete, But Further Uncertainty Looms

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