Pound pushes higher against dollar as aggressive US interest rate cut expected

The pound (GBPUSD=X) has rallied against the dollar, with the US currency trading near its lowest levels of the year as the US Federal Reserve prepares to deliver a rate cut.

It is all but certain that the Fed will deliver a cut on Wednesday.

A 25 basis-point drop would be a pivotal move, as many investors hope the decision could lower borrowing costs for companies and improve overall earnings growth.

However, a more aggressive 50 basis point cut would mark the biggest single rate cut in 16 years and the need for such a big reduction would spark concerns of economic trouble ahead.

Former New York Fed president Bill Dudley said there's a "strong case" for a deeper cut as FOMC members attempt to manoeuvre a "soft landing" of the economy. This view, combined with reports from the Financial Times and the Wall Street Journal indicating a split among policymakers, has heightened expectations for a 50-basis point reduction.

Meanwhile, the likelihood of a 25-basis-point reduction fell to 37%, down from 50% at the end of last week, according to the CME FedWatch Tool.

Read more: US Federal Reserve expected to cut and Bank of England set to hold interest rates

“Historically, when the Fed has started the rate cut cycle with a larger 0.5% cut, it has preceded some awful returns in equity markets. The latest instance was in 2007, which preceded the 2008 financial crisis, and before that, the tech bubble market rout in the early 2000s,” said Joe Tuckey, head of FX analysis at Argentex.

A larger rate cut could imply worries about economic strength and growth ahead, he added.

“This can have ramifications for the dollar, which can often be supported in times of stress. The larger cut may well drive the dollar to new lows for this move, while a 0.25% cut would likely initiate far less currency volatility,” Tuckey said.

The overnight lending rate stands at 5.25% to 5.5%. A 25-basis point reduction would bring the target range to 5% to 5.25%, while a more aggressive 50 basis point cut would lower it to 4.75% to 5%.

If the Fed decides to cut its key interest rate by 50 basis points, it will be important to note how central bank justify the need for a jumbo rate cut instead of a 25-basis-point cut, according to Quincy Krosby, chief global strategist for LPL Financial.

Read more: FTSE 100 LIVE: European markets higher as traders look to central bank decisions

“Any hint of an emergency propelling their thinking would have the dollar weakening at a faster clip against global peers, while a rationale based on inflation easing at a pace that suggests keeping rates significantly higher is no longer warranted should keep the dollar from falling decisively further,” Krosby wrote in a note.

An expected decision to leave UK interest rates unchanged at the Bank of England on Thursday is also said to be helping.

"For now, the ramped up Fed cut expectations is having a deleterious effect on the USD broadly, and GBP/USD specifically as the BoE is expected to hold rates steady when it delivers its rate decision the day after the FOMC," said Paul Spirgel, a Reuters market analyst.

However, the pound rally might come to an abrupt halt if the Fed decides to go with a smaller cut.

"Sterling is vulnerable should the Fed only cut 25bp," said Clyde Wardle, senior EM FX strategist at HSBC.

A 25-basis point cut scenario would see the dollar recover, "especially given the extensive pricing for rate cuts already factored into markets and signs of excessive short USD positioning", he added.

The Fed’s cut would come on the eve of the September meeting of the Bank of England’s monetary policy committee (MPC), which is widely expected to keep the UK base rate on hold at 5%, after it reduced rates in August.

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