The “smile theory” responsible for this battered and oversold exchange rate

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The exchange rate between the pound and the dollar fell to the 1.27 zone in a sudden drop that makes it vulnerable to further losses, especially if a sell-off in the global market intensifies.

According to analysts, the recent rise in the value of the US dollar – the main driver of the downward momentum in GBP/USD – is based on deteriorating global investor sentiment as opposed to developments in interest rate markets.

“While much of the US dollar’s strength this year has come from the impetus of rising US dollar-denominated interest rates, this latest round of dollar strength appears to stem from risk aversion. said Stephen Gallo, European head of currency strategy at BMO Capital.

This underlines why it is so difficult to bet against the dollar: it is a winner in all weathers and this potentially invites further weakness in GBP/USD.

“Cable (GBP/USD) suffered a second loss in a row, crashing into the low zone of 1.27 from 1.30+ at the start of last week. Queen’s money is further vulnerable to the the rapidly developing cost of living crisis in the UK, as evidenced last week and this is the lowest level for cable since September 2020,” says Mathias Van der Jeugt, analyst at KBC Markets.

Daily GBP/USD with RSI

Above: GBP/USD at daily intervals, with the relative strength index below, indicating oversold conditions. (Set your exchange rate alert here).

The chart above shows the Pound’s relentless bearish trend against the Dollar, but with the Relative Strength Index (RSI) in the lower pane.

The RSI is now reading below 30 indicating that the market is oversold.

As such, for oversold conditions to subside, some short-term relief may be in store.

That said, rallies will be sold under current conditions.

“The decline in global markets has boosted safer gaming, pushing the US dollar to new two-year highs. The dollar hit 2020 highs against the euro and the pound, while it hit its highest level in more than a month against the Canadian dollar,” says market analyst Joe Manimbo. senior at Western Union.

Manimbo adds that “silver remains in fashion, given the bleak outlook for global growth and growing expectations that the Fed will make significant interest rate hikes to fight inflation in the coming months. “.

Global markets sold off at the start of the new week on news that Beijing could be the last Chinese megacity to be locked down.

As authorities pursue a “zero covid” approach, the prospect of the world’s second-largest economy and engine of global growth suffering a significant downturn is high.

Increased congestion in global supply chains is also likely, adding to already strong inflationary pressures.

This is ultimately favorable to the dollar.

“According to the so-called ‘smile theory’ of USD movement, the USD tends to rally in times of financial market distress. These risk movements tend to look like spikes,” says Gallo. .

He explains that the “smile theory” also observes that the USD also rallies in boom times when growth is out of control, as the USD typically rallies when the Fed raises rates, with the Fed typically tightening policy more aggressively. than other major central banks.

“What appears to have happened in less than a week is that we went from a Fed-on USD rally to a risk-free USD rally with no downtime in between. We would attribute most of the change market tone to the latest developments in China,” says Gallo.

Sharon D. Cole