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Analysts at Westpac expect the dollar to turn around and pull back towards the middle of the year, at which point the pressured pound could stage a more sustained rally.
The exchange rate between the pound and the dollar has come under considerable pressure in recent days, with markets pushing the pair to new two-year lows following the Bank of England’s policy decision in May.
But the exchange rate has been falling since May 2021 when a broader dollar rally began and eventually continues to this day, hitting a new 19-year high on May 09.
It is therefore the dollar juggernaut that should be stopped and forced to retreat if the pound-dollar rate were to make a more sustained recovery.
“The market bid for the US dollar remains strong. But as uncertainties move away from the middle of the year, the trend should reverse,” said Elliot Clarke, macro strategist at Westpac in Sydney.
The dollar rallied on a combination of US economic outperformance, associated expectations of higher Federal Reserve interest rates and a major retracement in global investor sentiment.
By turning off the taps, the Fed is draining liquidity from the global economy, just as it grapples with growth issues related to China’s Covid response and the war in Ukraine.
This context is very bullish for the countercyclical dollar.
“Peaking US rate expectations and heightened market concerns over China’s COVID-zero policies also supported the US dollar,” Clarke said.
The US dollar index – a measure of the broader value of the dollar based on key dollar exchange rates – hit its highest level since 2003 on May 09, when it hit 104.18.
Above: The dollar index hit a new 19-year high on 09 May.
Westpac says the strong rally in the dollar index will ultimately be challenged, however, when two important components of this index refine their feet: the British pound and the euro.
“The worries that have hit the euro and the pound should slowly ease, laying the groundwork for a reversal,” Clarke said.
The two European currencies are expected to rally around 3% against the dollar by year-end, a view that hinges on the dissipation of risks to the regional outlook and a broadening of the global recovery.
The assumption is that the regional risk posed by the war in Ukraine will fade as the preeminent concern for the markets.
“If the decline for the continent due to Russia’s invasion of Ukraine were to reverse, the euro would outperform over the period,” Clarke said.
Westpac expects the euro-dollar exchange rate to end 2022 at 1.09 and increase to 1.15 through 2023.
The forecast for the exchange rate between the pound and the dollar should increase to 1.27 by the end of 2022 before expanding to 1.34 by the end of 2023. exchange rate here).