Finally, the market has it right for the Bank of England…but not for GBP…
Market expectations for the Bank of England (BOE) indicate that it is almost a forgone conclusion that a rate hike will be announced by the BOE this week. This wasn’t always the case. Until September, expectations for a rate hike this year had bounced between around 10% to 60%, and mostly toward the bottom end of that range. So why does the market have pricing wrong for GBP? Finally, the market has it right for the Bank of England…but not for GBP…
The turmoil surrounding Brexit negotiations and the uncertainty over the future economic arrangements have been a key reasons why investors have believed it unlikely that the BOE would raise interest rates. Indeed, the rebound in GBP stalled as European Chief Negotiator Michel Barnier and his UK counterpart David Davis traded uneasy statements back-and-forth about the status of the discussions. However, ongoing inflation pressure, a more hawkish tone from BOE Governor Carney and resilient economic numbers have been the reasons for our long held view that the BOE would hike rates in 2017. The knee jerk rate cut triggered by the EU referendum result in June 2016 has proven to have been unnecessary and the current aggressively accommodative stance of the central bank is now counter to its objective of price stability.
Downside risk för EUR/GBP
While GBP appears well valued against the US Dollar, real interest rate differentials between the Eurozone and the UK are supportive of further gains in GBP against the Euro. Indeed, we expect further downside for the Euro, which we feel remains overvalued, with the European Central Bank ECB) striking a much more cautious tone than the BOE. Although ECB President Draghi has announced a ‘downsize’ of its asset purchase program, he noted the need for ‘continued support from monetary policy’ as ‘domestic price pressures are still muted’. With no rate hikes on the horizon, investor positioning looks stretched, hovering near record highs, and EUR/GBP will move back into the 0.84-0.88 range it was trading in for the majority of 2017. Market consensus for EUR/GBP is for 0.90 by year-end. So while the market has it right for the BOE, it has it wrong for GBP.
Martin Arnold, Global FX & Commodity Strategist at ETF Securities
Martin Arnold joined ETF Securities as a research analyst in 2009 and was promoted to Global FX & Commodity Strategist in 2014. Martin has a wealth of experience in strategy and economics with his most recent role formulating an FX strategy at an independent research consultancy. Martin has a strong background in macroeconomics and financial analysis – gained both at the Reserve Bank of Australia and in the private commercial banking sector – and experience covering a range of asset classes including equities and bonds. Martin holds a Bachelor of Economics from the University of New South Wales (Australia), a Master of Commerce from the University of Wollongong (Australia) and attained a Graduate Diploma of Applied Finance and Investment from the Securities Institute of Australia.
ETF Securities FX Research: Upside potential for GBP after UK election
Highlights
We expect that the British Pound (GBP) will experience a period of consolidation ahead of the UK election in early June, as polls for PM May see-saw.
Investor sentiment has rebounded strongly, albeit from record levels of pessimism. We expect that the worst-case scenario surrounding Brexit negotiations has already been priced in for GBP.
Fading political risk, higher real rates, and a resilient economy will see GBP post gradual gains in H2 2016, potentially targeting the 1.35 level against the US Dollar.
Consolidation ahead of UK election
We expect that the British Pound will experience a period of consolidation around current levels ahead of the UK election in early June. The latest polling indicates that Prime Minister May’s lead has declined, prompting a modest pullback in the local currency. We expect that although GBP could soften further in coming weeks, as the Conservative party’s lead see-saws, but believe it will stay above key support of 200-dma, which is currently 1.2595.
Any further decline in PM May’s popularity could see a rise in GBP volatility, as the election result becomes more uncertain. Sterling has historically reacted negatively to volatile periods. There is a strong inverse relationship with Sterling exhibiting weakness during periods of heightened volatility.
Currently, global currency volatility is moderating as political uncertainty fades. While a more benign volatility environment will be supportive of gradual gains in GBP, we expect this to be increasingly apparent following the June 8th election.
Investors more optimistic
Investor positioning has begun to rebound from the lowest levels on record in the futures market, indicating that there is growing optimism for the UK’s economic prospects as ‘Brexit’ negotiations begin. Although still in negative territory, GBP net shorts have more than halved since the record pessimistic positions seen at the end of March 2017.
Investors have become more positive on the outlook for GBP because the domestic economic environment has remained resilient.
Financial sector key for GBP
We expect that the worst case scenario has already been priced in regarding the Brexit negotiations and its impact on the economy and the financial services sector in particular. In coming years, a rising rate environment and further clarity surrounding the EU-UK negotiations should be reflected in rising banking sector valuations.
A 2017 House of Commons Library briefing paper indicated that the financial and insurance services sector contributes over 7% of the UK’s Gross Value Added, a measure of the value of goods and services produced in the UK. Additionally and importantly a supportive factor for the local currency, the financial and insurance sector generates a trade surplus of the equivalent of 3% of UK GDP. Nonetheless, the Bank of England expects some softer numbers from the household sector as wage growth has been revised down at the same time that inflation is rising.
Price pressures apparent but fading
Inflation has breached the Bank of England’s target to the upside and is now at the highest rate since July 2013. In April, CPI rose 2.7% from a year ago, while core inflation rose to 2.4% from 1.8%. Imported inflation resulting from the weaker GBP has been one of the main avenues for inflation lifting in 2017, via imported food and fuel. However, the impact of currency weakness is beginning to fade. The Bank of England noted the rise in the GBP since its previous inflation statement in February, which will help moderate the rise in import prices. GBP has risen 4% since but remains 12% below the post EU Referendum levels of 1.48.
With headline inflation expected to peak near current levels, we believe that real rates are forming a bottom. Accordingly, GBP has responded in line with the modest rebound in real yields and we expect the gradual move higher in yields to continue. Not only do we expect the Bank of England to reverse the Brexit-induced rate cut of last year, but inflationary pressures are expected to moderate as the impact of the exchange rate plunge on prices begins to fade.
If the recent upward pressure in core CPI begins to gain momentum, the central bank will need to move more quickly to dampen inflationary expectations. Currently only one MPC committee member is voting for a rate hike, but that could quickly change post-election.
The bottom line…
After the election, as FX volatility continues to moderate, GBP could again test the 1.30 level and potentially break to the upside as the domestic economy remains resilient, targeting 1.35.
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The Supreme Court has upheld the High Court’s decision that requires the UK Parliament to vote to trigger Article 50 in order to invoke the two-year negotiation timeline to exit the EU. Brexit is still likely to happen, but is likely to be delayed by a government debate on whether and when to trigger it.
Today’s Supreme Court decision was widely anticipated, with GBP rebounding in recent days from its post-EU Referendum lows. UK Prime Minister May appears to have been resigned to the fact that the UK Parliament would have some say in the Brexit outcome, after last week indicating that lawmakers would vote on the final Brexit framework. However, the Supreme Court decision is another blow to the PM, who has taken a hard line in trying to implement what she terms ‘the will of the people’. We now expect the Government to table an extremely short Bill into Parliament with the aim of retaining its March deadline – however it is widely expected that pro-European MPs and Lords are expected to table amendments in an effort to either delay the process or bind the Government to specific negotiating positions. Most notably, a Labour spokesperson has confirmed that the Opposition will seek to amend the Bill to “build in the principles of full, tariff-free access to the single market.”
The one highlight for Prime Minister May is that the devolved Parliaments do not need to be consulted for triggering Article 50.
The free movement of people and EU budget contributions were also both critical determinants for the UK voters in deciding to leave the EU. Although these will remain two of the main goals for the Conservatives, it remains to be seen who the UK Government will be negotiating with, with many elections on the continent over the next two years. Indeed, the German Socialists have lost the EU Parliament Presidency which could potentially split the Parliament and make any Brexit negotiations with the UK more messy and acrimonious if they take a hostile position against the current Italian European People’s Party President.
Nonetheless, we expect the Pound will remain supported in the near-term, as negotiations begin and investors gain an understanding of the underlying issues and the timeframe for the exit process. A ‘hard Brexit’ is not our favoured scenario, but Sterling is likely to remain volatile and range bound in trading in 2017, as details of the Government’s negotiations with the EU trickle through to the public. Although range bound, investors will have plenty of opportunity to get exposure to the Pound, as it is likely to trade in a wide range – from 1.21-1.27 against the US Dollar in 2017.
Martin Arnold, Global FX & Commodity Strategist at ETF Securities
Martin Arnold joined ETF Securities as a research analyst in 2009 and was promoted to Global FX & Commodity Strategist in 2014. Martin has a wealth of experience in strategy and economics with his most recent role formulating an FX strategy at an independent research consultancy. Martin has a strong background in macroeconomics and financial analysis – gained both at the Reserve Bank of Australia and in the private commercial banking sector – and experience covering a range of asset classes including equities and bonds. Martin holds a Bachelor of Economics from the University of New South Wales (Australia), a Master of Commerce from the University of Wollongong (Australia) and attained a Graduate Diploma of Applied Finance and Investment from the Securities Institute of Australia.
2016 has been full of surprises and can be divided into three distinct phases defined by the EU referendum and US election.
Currently the market is in a period of re-pricing due to Trump’s proposed fiscal expansion plans.
The USD looks likely to hold onto recent gains, while the EUR look vulnerable to political uncertainty in the year to come.
Against all odds
Surprises have been commonplace in 2016 and have ensured that volatility has remained a prominent feature of the world’s currency markets. The year can almost be divided into three distinct phases marked around the shock outcomes in both the EU referendum and the US presidential election. In the period up to, and the month following, the Brexit vote, concerns over the economic impact of the referendum and reduced expectations of monetary tightening in the US saw safe havens like the JPY soar against the GBP and USD (rising 26% and 16% respectively from 1st January to the 6th July). These moves moderated somewhat until the US election, where Trump’s shock victory ushered in a complete shift in market assumptions and a corresponding re-pricing of financial assets. This is the current phase that we find ourselves in, characterised by the strongest trade weighted USD in over 14 years and a sharply weakening JPY. Going into 2017, we see healthy prospects for US growth and inflation buoying the USD, while in Europe the single currency risks being pressured by political uncertainty.
Click to enlarge
US reflation?
Markets appear to have interpreted Trump’s victory as a signal that the US will benefit from a large fiscal stimulus and infrastructure package in the years to come, helping to deliver both growth and inflation. While a lot of the details surrounding Trump’s future plan are currently uncertain, what seems clear is that the recent increase in inflation expectations have prompted the US Federal Reserve to pursue a more aggressive rate hike path. Should they follow through with the proposed three hikes in 2017 we see recent gains in the USD as being broadly sustained, although a near term pullback in the next few months may be due.
Populist sentiment tested
In Europe, scheduled parliamentary and presidential elections in a majority of the bloc’s largest nations have potential to test the Euro. Matteo Renzi’s recent resignation is a signal that anti-establishment sentiment on mainland Europe remains elevated and the growth of populist parties is not as remote a risk as market participants once thought. Combined with a European Central Bank (ECB) committed to at least another 12 months of asset purchases, risks for the EUR appear skewed to the downside.
Transitional Brexit deal to be brokered
Prospects for the GBP are centred on the progress of Brexit negotiations and the UK government’s ability to deliver an effective transitional agreement offering protection for Britain’s more exposed sectors, such as finance. We remain bullish on the currency and believe that it is currently trading near its structural nadir (see: GBP reaches rock bottom). However, it will remain volatile as markets scrutinise any plan Theresa May puts forward before the self-imposed March deadline for Article 50.
Investors wishing to express the investment views outlined above may consider using the following ETF Securities ETPs:
Currency ETPs
GBP Base
ETFS Long EUR Short GBP (GBUR)
ETFS Short EUR Long GBP (URGB)
ETFS Long USD Short GBP (GBUS)
ETFS Short USD Long GBP (USGB)
USD Base
ETFS Long GBP Short USD (LGBP)
ETFS Short GBP Long USD (SGBP)
ETFS Long EUR Short USD (LEUR)
ETFS Short EUR Long USD (SEUR)
EUR Base
ETFS Long USD Short EUR (XBJP)
ETFS Short USD Long EUR (XBJQ)
ETFS Long GBP Short EUR (EUGB)
ETFS Short GBP Long EUR (GBEU)
3x
ETFS 3x Long USD Short EUR (EUS3)
ETFS 3x Short USD Long EUR (USE3)
ETFS 3x Long GBP Short EUR (EGB3)
ETFS 3x Short GBP Long EUR (GBE3)
ETFS 3x Long GBP Short USD (LGB3)
ETFS 3x Short GBP Long USD (SGB3)
ETFS 3x Long EUR Short USD (LEU3)
ETFS 3x Short EUR Long USD (SEU3)
ETFS 3x Long USD Short GBP (USP3)
ETFS 3x Short USD Long GBP (PUS3)
ETFS 3x Long EUR Short GBP (EUP3)
ETFS 3x Short EUR Long GBP (SUP3)
5x
ETFS 5x Long GBP Short EUR (EGB5)
ETFS 5x Short GBP Long EUR (GBE5)
ETFS 5x Long USD Short EUR (5CH5)
ETFS 5x Short USD Long EUR (5CH6)
ETFS 5x Long USD Short GBP (USP5)
ETFS 5x Short USD Long GBP (PUS5)
Basket
ETFS Bullish GBP vs G10 Currency Basket Securities (LGBB)
ETFS Bearish GBP vs G10 Currency Basket Securities (SGBB)
ETFS Bullish USD vs G10 Currency Basket Securities (LUSB)
ETFS Bearish USD vs G10 Currency Basket Securities (SUSB)
ETFS Bullish EUR vs G10 Currency Basket Securities (LEUB)
ETFS Bearish EUR vs G10 Currency Basket Securities (SEUB)
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The UK Treasury is set to miss its budget target again in 2016/17 and has no intention to return the budget to balance during this parliament. Although fiscal deficit is expected to jump to £59bn (from £39bn in March) in 2017/18, it’s a good sign that the Government is trying to offset the negative impact of Brexit and not leave monetary policy to do all the heavy lifting. Chancellor Hammond will borrow around 2.5% of GDP more than was the objective in March over the next five years. Brexit blows the UK Budget
The Office of Budget Responsibility (OBR) forecasts that economic growth of 2.1% in 2016 to slump to 1.4% 2017, and then rebound to 1.7% in 2018. In turn, the Budget is not expected to be balanced by 2020/21, a £3obn swing into the red since March. Nonetheless, as a result of the EU Referendum, the UK economy needs supporting, and fiscal policy stimulus is required. Importantly, alongside tax reform, productivity is a focus, with £23bn to be spent on infrastructure and innovation over the next five years.
(click to enlarge)
Economic growth as a result of the EU Referendum, however, is estimated to be 2.4% lower over the forecast period than it would be otherwise. As a result, confidence in the economy is already at a low ebb. Although consumer confidence has rebounded from its post-Brexit slump – the lowest level in nearly three years – uncertainty remains over the structure of the UK-EU relationship and worse economic times are to come.
The damage to the UK’s credit rating has already been done. Weaker growth prospects led the UK to lose its AAA credit rating following the EU Referendum. Although ratings agencies have warned of a further possible downgrade, the result will depend on the negotiations surrounding the access to the European single market. To that end we expect that the ‘hard Brexit’ will not result and that a ‘middle of the road’ solution will be agreed, akin to that of Switzerland. However, we feel that the worst case scenario is priced in to both credit spreads and the British Pound.
Despite a blowout in coming years, the government estimates that net debt will decline by the end of the current parliament. Net debt to GDP is expected to rise to 87.3% of GDP in 2016/17 (from a March forecast was 82.6%), to 90.2% in 2017/18 (81.3%) and decline modestly thereafter to 89.7% in 2018/19 (79.9%).
While Brexit has blown the UK Budget, with concerns over growth and inflation set to rise, the Governments’ new policies are a helpful response to try and offset economic stagflation.
Martin Arnold, Global FX & Commodity Strategist at ETF Securities
Martin Arnold joined ETF Securities as a research analyst in 2009 and was promoted to Global FX & Commodity Strategist in 2014. Martin has a wealth of experience in strategy and economics with his most recent role formulating an FX strategy at an independent research consultancy. Martin has a strong background in macroeconomics and financial analysis – gained both at the Reserve Bank of Australia and in the private commercial banking sector – and experience covering a range of asset classes including equities and bonds. Martin holds a Bachelor of Economics from the University of New South Wales (Australia), a Master of Commerce from the University of Wollongong (Australia) and attained a Graduate Diploma of Applied Finance and Investment from the Securities Institute of Australia.
