GBP/USD Weakens as Diverging Fed-BoE Policies Fuel Dollar Strength

GBP/USD has fallen to a 3-month low despite only a 0.5% decline across Q3. The pair traded higher in July and August, but fell over 2% in September as the US dollar staged a strong recovery.

The pound weakened against several major currencies, including the Japanese yen, Australian dollar, and Canadian dollar, while rising modestly against the euro, New Zealand dollar, and Swiss franc.

As the Fed-BoE policy divergence continues to widen, the balance of risks points towards a downside bias for the pound against the US dollar in Q4. Headline UK inflation rose to 3.1% annually in August, its highest level since March, driven by higher energy prices from the Middle East conflict.

The Bank of England's near-term inflation forecast suggests CPI will rise to around 3.7% in Q4 2026 and 4.2% in Q1 2027. However, core inflation remains at 2.6%, while services inflation has remained unchanged at 3.4%. The labour market is also showing signs of slowing, with vacancies falling to their lowest level in five years and wage growth moderating.

Markets are pricing significant tightening from the Bank of England between now and July 2027, but higher energy prices create a difficult policy mix for Governor Andrew Bailey. The OECD suggests that policy is already restrictive enough to bring inflation back towards target, which contrasts with market expectations and could lead to rate-hike expectations being scaled back.

The U.S. economy remains resilient despite the ongoing conflict in the Middle East, rising energy prices, tariffs, and inflationary pressures. However, the Fed's preferred inflation gauge, core PCE, is expected to remain at 3.4%, well above the 3% target level. The possibility of further rate hikes has driven the U.S. dollar to a two-month high.