If you look at a GBP/USD chart, it is very misleading. Judging by just that chart, it looks like the British pound has been slowly but steadily gaining strength since making a second run at the post-Brexit lows on Jan 16th of this year. It has been a flat up channel, but it is still in place and pointed up none the less. This would make sense considering the recent UK CPI print of +2.9% year over year is much higher than the US CPI which as of this morning is currently running at only 1.6% YOY. It would seem that the Bank of England need to hike rates and raise them at a faster pace then the US. But the underlying story could spell trouble for the pound down the road.
When comparing the British pound to the euro, you see a different story. On Wednesday, the pound hit it’s lowest level of the year versus the euro and EU inflation is only running at 1.3% YOY (after hitting 2% in April, which was a four-year high). So what is driving the GBP/USD higher? It’s more about dollar weakness than about pound strength. Brexit is starting to become cumbersome and there is no end in sight, so the pound falling against the euro makes sense, but when looking at it versus the dollar Brexit comes into play in a different way. The economic effects were not fully understood by anyone when UK citizens voted 52% to 48% on June 30th of last year to invoke Article 50 and leave the EU. The first “cockroach in the kitchen” of Brexit negotiations is the “divorce payment” that the UK has finally acknowledge they owe the EU on the way out the door. It could be as high as €100 billion and for an economy the size of the UK’s, that is not pocket change. These are very tough negotiations and there is never just one cockroach in the kitchen. So it comes down tot this; Janet Yellen just told congress rate hikes will be gradual, but they will happen. She also told them the Fed’s balance sheet will shrink, but it will be gradual. The Bank of England by contrast needs to raise rates to slow inflation, but really has to consider how an economic slowdown cause by higher rates could exacerbate problems caused by Brexit. The GBP/USD chart is still pointing up…but just a little bit of dollar strength could really pound the pound.