Should you buy or sell the British pound after nose diving yesterday?

The trading week ended yesterday with some extreme long US dollar positioning. The greenback gained across the FX dashboard – EUR/USD lost -1.5%, AUD/USD -1.70%, NZD/USD – 1.8%, to name just a few US dollar pairs and their performance last Friday.

But there is one currency that performed particularly badly. That is the British pound.

Sure enough, the US dollar’s strength is undeniable. Yet, the pound’s weakness is nothing short of impressive as well.

The main exchange rate, GBP/USD, closed the trading day down sharply, -3.23%. Even though the FX market is known for its wild moves, such a decline is unusual by every historical standard. With yesterday’s move, the GBP/USD exchange rate declined by about -20%YTD.

So what triggered such a sharp move lower that the GBP weakened against all its peers? More importantly, for traders – is this an opportunity to buy the pound, or more weakness lies ahead?

UK mini-budget spooked investors

The UK Chancellor of the Exchequer announced a mini-budget that scared investors away. It delivers massive fiscal easing by cutting taxes and supporting energy costs.

Also, a planned corporate rate tax hike from 19% to 25% has been abandoned.

The announcement sent gilt yields through the roof, as they soared by most even when compared to events such as the COVID-19 pandemic or the 2008-2009 global financial crisis.

Fiscal easing at a time when inflation is close to double-digit territory spooked investors. As such, the pound’s weakness only accelerates the inflation spiral, and so yesterday’s announcement triggered a wave of selling.

Why the need for fiscal stimulus?

At a time when central banks around the world race to tighten the monetary policy, yesterday’s mini-budget announcement came as a surprise. So why would the UK economy need fiscal stimulus?

One explanation is that UK investment lags behind other big high-income countries. The chart below shows that after the Brexit referendum in 2016, UK investment declined while investment in other countries had an ascending trend.

1.20 acts as a pivotal level for GBP/USD

Over the years, 1.20 acted as major support for the GBP/USD exchange rate. The recent break washed away the COVID-19 pandemic lows, and there is nothing to support the pair on its way to parity.

However, things may change in a blink of an eye. An exchange rate reflects the value of one currency in terms of another.

The exchange rate may stabilize depending on how the Bank of England responds. But one thing is sure – the pound nose-dived in 2022, and it looks more and more like an emerging market currency.