This blog was originally written in November 2022 for the Society of Technical Analysts Market Technician Journal
Foreign exchange market spot (USD) and cross rate (non-USD) trends are very easy to see and make money on, in hindsight. Trying to forecast FX rates and beat the forward rate on a consistent basis (the simple interest rate differential between two currencies) is not that simple. Speculating in the FX market and making money on a consistent basis is not that easy either. Then there is Cable (GBP/USD), which is a whole different kettle of fish altogether when it comes to forecasting and trading.
Cable is one of the big currency pairs. According to the April 2022 survey from the Bank for International Settlements, GBP/USD makes up around 9.5% of the total daily volume. The total daily over-the-counter volume in the FX market was $7.5 trillion in April according to the BIS, so Cable trading has some weight.
However, my experience with Cable is unless you ‘have to’ trade it, many professional investors avoid it. On a visit to Swiss fund and banking clients they were quite happy to tell me that Cable swung around too much for them to consider taking on the risk. This reputation for being a swinger was confirmed by many in 1992 as GBP was thrown out of the European Rate Mechanism. The EU referendum in June 2016 saw GBP fall sharply and remind investors of how fast the rate could move. And GBP convulsions on the back of the ‘fiscal event’ from PM Truss and Chancellor Kwarteng in late September/early October 2022 seemed to also remind investors that GBP can swing sharply.
FX market basic forecasting
There are many different models that economists, strategists, corporate hedgers, technical analysts and others use to forecast FX rates. Many long-term forecasts could use a purchasing power parity (PPP) approach (or a modified version of this). One of the more famous ‘tongue-in-cheek’ approaches to this is the ‘Big Mac index’ from the Economist magazine which tries to estimate the correct FX level to equalize the cost of a burger around the world. For traders and hedgers of course, this is not a great way to manage trades or risk as the PPP and real spot or cross rate can be different for long periods of time.
An academic summary paper looked at currency fund managers returns from 2005-2008 and explains some of the typical models that are used. Carry (interest rate differentials), trend (or momentum), value (PPP) and volatility are the main ones. Many speculators, hedgers and other risk managers use a blend of these models. The actual results from the paper are interesting, but keep in mind that this is a very small sample in terms of funds and time periods.
For our purposes, carry can be a big factor in currency trend determination. Many FX participants remember that GBP used to have an interest rate premium over the USD. The chart above shows a weekly chart of Cable and the spread between US and GBP 3-month rates. The GBP rate premium has eroded over the last decade+.
Interest rate carry models can also use swap rates and bond yields across many tenors. The chart above shows the spread between the US 10-yr. note yield and the UK 10-yr. gilt yield. There have been many occasions when the US bond yield was above the UK one, but the general trend direction of the rate differential does seem to coincide with the general trend in Cable. From experience, actually trading this difference on a short-term basis can be tricky, and using this for long-term forecasts may depend on being able to forecast interest rates successfully. I use the above as references for forecasting.
The chart above shows a monthly chart for Cable. This is as basic as it gets, but it is good to keep things simple sometimes. The horizontal blue line is just above $1.40 and serves to mark what looks like a decent long-term pivot point. We will need a decent push above this line to get excited about $1.70 and higher prospects. It does seem that Cable likes to mean revert to this line over time though.
The chart above is a typical chart that I use when looking at most markets. The daily candle study makes it easy to spot up days and down days. The 20-day moving average sums up an average month of trading (business days), the 60-day moving average is 3-months of trading and the 250-day moving average is 12-months of trading. And yes, I once had a conference participant point out that in his country, a year had 365 days. Ho-ho. The potential reversal (inverse head and shoulders) building in September/October 2022 is clear here, as is the cross of the 20-day moving average above the 60-day moving average. The momentum indicator is the difference between the spot rate and the 250-day moving average and can give trend and divergence signals. Overbought/oversold indications are best seen in an RSI or stochastic indicator study.
The chart above shows a ‘trading picture’ that I find useful. The model ranking at the bottom gives a quantitative trend indication within a +/- 10 range. Some of our models use a turn above -6 to cut shorts, and turns above +2 to trigger a long position, for example. The chart uses the daily candle study bounded by 1 and 2-standard deviations (20-day), not the moving average standard deviation that Bollinger bands display. Options markets use the standard deviations as part of the pricing process, and these bands can give some insight into probable ranges.
All of the above studies and charts form part of the picture that can give insights for forecasting, trading and risk management. Sometimes though it pays to have built up years of ‘ticker watching’ or ‘tape reading’ experience. My first proper technical analyst job involved staring at various Telerate (pre-Bloomberg interbank trading and price quote machine) and Reuters screens and jotting down FX price moves. Then we would plot these as point and figure charts on the screens for dealers to look at – a human charting machine!
The chart above is the hourly chart of GBP/USD during the ‘fiscal event’ debacle. The new all-time low (Refinitiv) was set in Asian trading near $1.0380 on the 26th of September (first circle on the chart). By the time London desks were filling up, Cable was above $1.05 again (previous all-time low was near $1.0520 in 1985). The dip on the 28th of September (second circle) was key for tape readers as this was a shot by London traders (and early NY) to have a bash at breaking the 1985 low. But GBP failed to break this low, suggesting that outside of the thin Asian market, there was real demand for GBP at these low levels.
Using all of the above and it is clear that interest rate differentials are not supportive of GBP yet. However, there is a chance that the Fed pauses their rate hikes in 2023 below 5%, and the spread over short-term GBP rates may narrow. The same narrowing of the yield spread may be seen in the 10-yr. bond yields as well next year, eroding USD bull signals. The other charts show upside potential on ‘reversion to $1.40+’ plays, moving average spreads rising, and potential reversal patterns. The behavioural signal that was given by the rise in GBP demand on the 28th of September is clear as well, suggesting that a low is in place. This focuses the mind on gauging tests of resistance, and seeing if dips continue to draw out buyers. Higher highs, and higher lows will be key for GBP bulls. Back to $1.40 and maybe higher? Time will tell. GBP bears will need to see if the 250-day moving average (near $1.25 in mid-November 2022) can hold off Cable upswings (supply stepping up on upticks).
Keywords: GBP USD Cable FX Currency