GBP/USD surges towards 1.3700 as dollar dives post-CPI, but now looking overbought

• GBP/USD has surged in recent trade and is now testing the 1.3700 level and a key downtrend.
• USD is weakening after the latest CPI report and Powell’s remarks on Tuesday failed to spur fresh hawkish Fed bets.
• But GBP/USD now looks quite overbought/overstretched on a few metrics, which could hamper further gains.

GBP/USD upside has accelerated in recent trade as the US dollar suffers substantial post Consumer Price Inflation (CPI) data weakness, with the pair eyeing a bullish break above a key long-term downtrend and the key 1.3700 level. At current levels just below the big figure, cable is trading at its highest since early November, up just under 0.5% on the day and now looking at gains of about 0.8% on the week. If the pair can close out the week at current levels and in the green, that would mark a fourth consecutive week of gains during which time GBP/USD would have rallied a stunning 3.5%. The pair is over 4.0% up from its mid-December lows in the mid-1.3100s.

The rally over the last few weeks was initially driven by factors including a drastic improvement in risk appetite as it become clear the Omicron variant would be much less severe, thus enabling the UK economy to avoid lockdowns. That then in turn boosted the market's confidence that the BoE will follow up on its 15bps December rate hike with multiple further 25bps rate hikes in 2022. But the most recent leg higher has more to do with the US dollar, which failed to garner any meaningful impetus last week amid a sharp hawkish shift in the market’s expectations for Fed policy. Indeed, the dollar has been sharply declining on Tuesday and Wednesday across the board after Fed Chair Jerome Powell’s testimony and the latest US inflation report failed to spur fresh hawkish Fed bets.

Though the fundamentals (tight labour market, hot inflation, hawkish Fed) are arguably still very much supportive of a stronger dollar in 2022, FX markets seem to be in the process of flushing out overly one-way dollar positioning. Indeed, the most recent CFTC positioning data showed Dollar Index long positioning at a 52 week high in the week ending on January 4. A break above the downtrend linking the July, September and late October highs and the 1.3700 level in GBP/USD could open the door to an extension of upside to test October highs above 1.3800.

But cable bulls will be growing increasingly wary of the pair entering short-term overbought conditions. GBP/USD’s 14-day Relative Strength Index (RSI) recently entered overbought territory (i.e. above 70) for the first time since February 2021. Back then, after surpassing 70 in the RSI, cable had a few more good days before then abruptly turning lower. Meanwhile, GBP/USD’s Z-score to its 50-day moving average has now risen above 2.0 (implying it it more than two standard deviations from its 50DMA). In the last 18 or so months, a Z-score above 2.0 has suggested consolidation or a slower pace of gains ahead. Indeed, when looking at the past ten years, GBP/USD five, 21 and 65 day returns after a day when its Z-score to 50DMA was above 2.0 is on average negative by 0.2-0.4%.