Pound Sterling's recovery from its post-Tory party conference lows has seemed nothing short of miraculous.
The currency had little going for it after the referendum: a gaping Current Account deficit, few international friends, a government without a leader - but nevertheless, it rebounded Lazarus-like, gaining a full 6% versus the Dollar between October and December to reach highs of 1.27 last week.
The initial euphoria now spent, analysts are divided about where the pair is likely to go next – can it really move any higher?
Analysts at Investec, think so and are decidedly bullish GBP/USD.
Part of their stance comes from not being very bullish the Dollar half of the pair because they don’t see much more potential for strength.
Investec see the Dollar's rally as 'long in the tooth' and don’t see much more potential left.
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Indeed, this central view sees the investment bank also projecting a rise in the EUR/USD exchange rate through 2017.
They argue higher interest rate expectations are already ‘priced in’ to the exchange rate.
Normally a higher interest rate drives up its domestic currency as it attracts more foreign capital to home shores.
But whilst the Federal Reserve is expected to raise interest rates in the U.S by two or three times in 2017, Investec take the view that this knowledge is already baked into the Dollar.
The Pound, meanwhile, is likely to gain due to having fallen to ‘undervalued’ extremes and therefore probably likely to rebound.
Investec see a neutral effect from the Bank of England (BOE) who are neither likely to cut or raise interest rates from their current low 0.25%.
Inflation is likely to rise but the BOE is unlikely to raise interest rates in response as it would normally do as the rise is likely to put down to the Pound’s low exchange rate, which makes foreign imported goods more expensive, rather than to growth.
Rising unemployment and low growth are further likely to prevent the BOE from raising interest rates to combat the inflation.
Nor is the BOE likely to cut interest rates because that would exacerbate inflation.
“Our expectation is that with UK Bank rate steady through 2017 and Fed rate moves ‘priced-in, we see sterling climbing a little above its extremely undervalued level we forecast $1.35 versus the USD end-2017,” concludes Investec’s Philp Shaw.
Analysts at J.P. Morgan, meanwhile, also see the Pound as undervalued, but they do not necessarily see this as leading to an ‘elastic’ rebound in value from oversold ‘extremes’ as Investec do.
This is because they do not think the models used to estimate ‘fair value’ are accurate.
For example, the common broad-brush REER model (Real Effective Exchange Rate) for assessing fair value has GBP/USD valued at 4-5% above the current exchange rate.
J P Morgan, however, argue that this is inaccurate and ‘fair value’ should, in fact, be lower.
Their BEER model has GBP/USD’s ‘fair value’ at about 3.5% below NEER as it takes into account the negative impact of Brexit on growth.
This means, according to BEER, that the exchange rate is at about ‘fair value’ at the moment.
BEER includes a worst-case scenario of a massive double digit hit to GDP from Brexit and given this now seems excessively pessimistic there might be cause to argue BEER is actually too pessimistic, and therefore expect a rebound in GBP/USD from here.
But BEER isn’t 100% accurate either say J.P. Morgan.
That is because BEER does not take into account the UK’s large Current Account deficit and that is their main reason for not expecting a rebound in GBP/USD post-Brexit.
“In the worst-case scenario set out by the UK Treasury, one in which GDP is 10% lower than the baseline, GBP’s fair-value would fall by 4%, which would mean the currency was broadly at fair-value.
“So yes, the currency is somewhat cheap insofar as it appears to discount the worst-case steady-state outcome for the UK economy post-Brexit.
“However, we are reluctant to draw a positive inference for GBP from this, in part because the BEER approach excludes any direct consideration of external balance,” says J P Morgan’s Head of FX John Normand.
He added:
“The more fragile a county’s external position the weaker the currency should be relative to a BEER-benchmark. And that surely is the reason that Brexit has been so pernicious for GBP – it has finally called into question the sustainability of the UK’s current account position.”
This leads J P Morgan to a much more sober forecast for the pair, adopting a stance of an extended period of consolidation between the upper 1.10s and the mid-1.20s, albeit with the proviso that volatile shocks which could push the exchange rate in either direction out of this narrow range.
Outlook for Exports
The accepted view has been that one of the upsides of a weaker Pound post-Brexit would be that it would UK exports more competitive and therefore potentially drive an export-led recovery in the economy.
Investec partially agree with the view that the weaker pound will give a “fillip to exporters” but they see much of the benefit being eroded by higher inflation, at 3% due to the same cause.
J P Morgan do not see any benefit as likely to come from the weaker pound, even though it helps exporters, because they see evidence of exporters using the opportunity to “increase profit margins” as they say rather than “growing market share.”
This is because exporters are using a cheaper Sterling to put up their sale prices rather than to increase volume by leaving the sales prices unchanged.
“Growth optimists should as well remember that hopes for an export-led recovery following the banking crisis were unfulfilled in part because exporters took the opportunity of a weak GBP to increase profit margins instead of growing market share. There is evidence of this happening once more as export prices are increasing at twice the rate of import prices (chart 5).”
Outlook for Investment
In relation to investment, the accepted wisdom has been that Brexit would result in a dramatic fall in business investment due to companies putting off plans to expand until after the cloud of uncertainty caused by Brexit had cleared.
Recent GDP for Q3 has to a certain extent undermined the concerns that investment would be scuttled by Brexit uncertainty as it grew both above Q2 and above expectations, showing remarkable resilience.
“The economy has held up remarkably well since the Brexit vote. Higher uncertainty has not led businesses to slash investment and hiring," says Investec’s Philip Shaw.
Both Investec and J P Morgan, however, see falling investment as a feature of the economy post-triggering of Article 50.
Soft or Hard Brexit?
Investec are optimistic about the chances of a Soft Brexit, seeing a high chance of a transitional deal, smoothing the way, in which the UK might buy acceptance into the EU trade club, as was suggested recently by Brexit minister David Davis.
JP Morgan hesitate to apply odds or quantify the possible outcomes of one type of Brexit versus another.
“We are relatively certain that Brexit means Brexit (i.e. the government will take the UK out of the EU in 2019), but beyond this have little confidence about the actual path or form of Brexit and find it challenging to benchmark the odds on a soft Brexit (one that more or less preserves the single market status quo through, for instance, transitional, time-limited membership of the EEA) versus a hard Brexit that accepts some restriction on trade (the most extreme and economically damaging variant involves the UK falling back on interim WTO-rules; other scenarios feature sector-specific arrangements),” remarked J P Morgan’s head of FX.
Overall the US Bank see the GBP/USD remaining in a range between 1.20 and 1.26:
“Cable to 1.20 by Q1/Q2 vs 1.26 previously, while the 1H peak in EUR/GBP is cut from 0.95 to 0.89. Cable recovers to 1.26 by end-2017 with EUR/GBP at 0.91,” said Normand.
