GBP/USD rallies to the mid-1.21s, despite big bets on a 6% Fed rate

KEY TAKEAWAYS:

• Traders are now betting on a higher peak interest rate from the Federal Reserve due to strong January employment data and recent comments from Fed officials.
• Options trades show some investors are anticipating a peak rate of 6%, nearly a full percentage point higher than the current consensus.
• Despite the shift in sentiment, overnight index swaps (OIS) still predict easing later this year, with the Fed's benchmark peaking at 5.17% in July.

What a difference a week makes!

After a series of hawkish comments from Federal Reserve policymakers and strong economic readings, traders are now betting on a higher benchmark rate, with several big wagers on the rate reaching as high as 6%, nearly a full percentage point higher than the current consensus, popping up in interest-rate options this week.

Previously, it was widely believed that the Fed was near the end of its tightening cycle after raising rates eight times in the past year, and that rates were already high enough to cause a recession that would require the central bank to reverse course this year. However, the strong January employment data, released last Friday, and recent comments by Fed officials have challenged this consensus.

According to Bloomberg, one trader amassed a large position in options that would make $135 million if the central bank keeps tightening until September, with buying of the same structure continuing Wednesday, alongside similar bets expressed in different ways. This marks a sharp turnaround from the big theme in the market last week, where traders increased bets on sharp rate cuts in the second half of 2023.

Overnight index swaps are still priced for easing later this year, but not nearly to the same extent as last week. Investors are now looking ahead to what the new interest-rate projections, to be published after the next policy meeting in March, may show, given that markets are now aligned with the last set of projections published in December.

Despite the recent shift in sentiment, the Federal Reserve is still expected to proceed with caution. New York Fed President John Williams stated during a Wall Street Journal event that the December outlook "still seems a very reasonable view of what we'll need to do this year." The final outcome will depend on inflation data to be released between now and the next policy meeting, highlighted by next week’s highly anticipated CPI report.

Traders' reactions to the Federal Reserve's policy are like a weathervane, constantly shifting to align with the latest economic data and official statements. Just like how a weathervane swings to indicate the direction of the wind, traders adjust their positions to reflect the current state of the economy and the future outlook.

In the current environment, the winds of economic data and Fed comments are shifting day by day, swinging that proverbial weathervane wildly and elevating market volatility.

Technical view: GBP/USD

Despite the recent shifts toward higher interest rate expectations from the Fed, pound sterling is gaining ground against its cross-Atlantic rival. As the chart below shows, GBP/USD is rallying to the mid-1.2100s today to recapture its 50- and 200-day EMAs.

From a technical perspective, the pair continues to put in higher lows, though strong previous resistance looms up at 1.2450. The short-term technical bias remains to the topside, though longer-term traders may want to wait for a confirmed breakout above 1.2450 to signal the uptrend that started in late September could extend above 1.2700.

A reversal below this week’s low at 1.1960 would shift the near-term bias in favor of the bears for a continuation toward the year-to-date lows in the lower-1.1800s

Source: StoneX, TradingView