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JP Morgan is Bullish USD heading into the second half of the year and identifies Pound Sterling as a candidate to absorb much of this strength.

In a midyear FX assessment, analysts at the Wall Street bank are pencilling in a steady decline for the Pound to Dollar exchange rate (GBPUSD) that suggests the rally of 2023 is at risk of capitulating.

"Stay bearish GBP/USD," says Patrick R Locke, Head of FX Strategy at JP Morgan in New York. Locke and his team see value in staying 'short' higher-beta currencies such as the Pound and New Zealand Dollar, while holding a bearish slant on European FX in general.

"Europe has not shown any sign of kicking its recent malaise," he says.

Betting on Pound Sterling underperformance has however proved an expensive proposition over recent months as the UK currency has emerged as one of the top-performing financial assets of the year so far.

The currency has defied the consensus forecast from the turn of the year for GBPUSD to be trading at 1.19 by this stage in June. A stronger-than-expected run of economic data and a more forceful Bank of England reaction function to inflation have been among the drivers of this consensus-defying performance.

But for JP Morgan, much focus must be placed on the Dollar, which remains the ultimate arbiter of overall foreign exchange performance.

Analysts look for a "regime shift" in global FX towards a more defensive backdrop which should prove supportive of USD strength in the second half of the year.

"Key to this shift has been the reversal of the strong growth momentum that was prevalent in 1H," says Meera Chandan, co-head of global foreign exchange strategy at JPMorgan.

Of note, data out of China is now missing expectations and European data momentum is also seen running out of steam.

"This less benign picture—one with fewer growth upgrades and more growth downgrades indicates that the dollar will no longer be pinned down by strong global growth and will instead be freer to respond to late-cycle concerns," says Chandan.

She notes core inflation has proven to be stickier, which has challenged the notion that central banks are nearing the end of hiking cycles and are in fact pushing them to do more, which has been reflected in further inversion of rates curves.

Above: Performance of the USD in 2023.

The UK has seen a particularly inverted yield curve as near-term bond yields are notably higher than longer-term dated yields, reflecting an investor belief near-term inflation will remain high before falling back over the coming years.

"This does not bode well for high beta FX and warrants a more defensive, bullish-USD view," says Chandan.

JP Morgan says the Pound will be weighed down by housing market stresses and persistent inflation, which will weigh on 'real' inflation-adjusted yields, and targets a move to 1.18 in GBPUSD.

JP Morgan forecasts Pound-Dollar to trade at 1.18 by year-end, before rising to 1.21 by the end of March 2024 and 1.27 by mid-June.

Elsewhere, the Australian and New Zealand Dollars are also seen remaining under pressure while the bank holds a 'tactical' short on EURUSD, targetting 1.05.

Risks to the pro-USD view include unexpected geopolitical 'wildcards' that include an improvement in relations between the U.S. and China and a détent in the war in Ukraine.

Lower global inflation prints, a sizeable China stimulus and constrained Federal Reserve rate hike expectations can also upend any pro-USD view.