GBP/USD Trapped in Range as Policy Rate Differential Vanishes

The GBP/USD exchange rate has been trading in a narrow range of 1.3150 to 1.36 for six weeks, with no clear direction. This is unusual because the pair is typically influenced by interest rates, but currently, the policy rate differential between the UK and US is negligible.

The Bank of England's base rate stands at 3.75%, while the Federal Reserve's target range is 3.50% to 3.75%. The difference is just 12.5 basis points in favor of sterling, which effectively means there is no carry trade influencing the pair.

Without a policy rate differential, the GBP/USD exchange rate has become a sentiment and flow instrument, making it more susceptible to market moods and trading activity. This shift in dynamics explains why the pair has been stuck in a range for several weeks.

The UK's 10-year gilt yield is 29 basis points above US Treasuries, which could indicate higher expected inflation persistence or fiscal risk. The Bank of England expects inflation to rise later this year due to higher energy prices, and the current yield spread suggests that market participants are pricing in these risks.