Analysts: GBP/EUR Exchange Rate's “Weakness is Behind us”

Consensus around the view that Pound Sterling has now fully absorbed Brexit negativity continues to grow.

With news that the UK Government will trigger Article 50 of the Lisbon treaty on Wednesday, March 29 the question has suddenly become all the more pertinent with nerves growing that the currency could be sitting on the precipice ahead of another leap lower.

Economist Nick Kounis at ABN Amro - the Dutch financial services giant - argues further notable downside in the British Pound is only likely were the UK to fail to secure a deal with the European Union after two years of negotiation.

“The main risk if no deal is struck is for the service sector. Goods trade is still possible under WTO rules but with tariffs, but possibilities for the service sector are more modest,” says Kounis.

In such a scenario, a reduction in Foreign Direct Investment could hit the economy and hurt Sterling given the large current account deficit the country runs.

Without investment inflows demand for Sterling would be diminished and the Pound would have to fall further.  

This negative outcome is actually a base-case expectation with strategists at Commonwealth Bank of Australia who have told clients they believe markets are being too kind to Sterling as they are expecting further notable downside in the exchange rate based on a number of reasons.

Importantly for CBA though, Brexit has not yet completed its assault on the currency.

March 29

The call from ABN Amro comes in the week it is announced that the UK government will seek to trigger Article 50 of the Lisbon Treaty on Wednesday, March 29.  

The trigger will start a two-year process for the UK to negotiate its future relationship with the EU.

Council President Donald Tusk announced that he will present the draft Brexit guidelines to the EU member states within 48 hours of the UK triggering Article 50.

However, a detailed stance will probably take longer to formulate and real negotiations may not start until June.

“Recent statements on both the UK and EU side suggest both camps are taking a tough line, which is logical at the start of any negotiation process,” says Kounis.

British Pound will Benefit on an Ultimate Compromise

Prime Minister May has said the UK will not be part of the single market or customs union and wants to start from a blank page so she does not need to negotiate under the current rules.

At the same time the EU has said they do not want the UK to ‘cherry pick’ the benefits of memberships, while getting rid of the responsibilities.

In particular, the EU insists that full access to the EU market is only possible with full freedom of labour.

“Our base case is that some balance between free trade, free movement and payments into the EU budget will be eventually agreed, though the outcome is obviously highly uncertain,” says Kounis.

Still, “a lot of bad news is priced in for Sterling, and under our base scenario, we judge that much of the weakness is behind us,” says Kounis.

In a major update to their foreign exchange forecasts released at the start of the month ABN Amro told clients they are now forecasting GBP/USD consolidation around recent levels to be a favoured scenario for 2017.

Analyst Georgette Boele however warns Pound Sterling could expect further losses against the Euro which is likely to enjoy a strong relief run as political risks in the Eurozone fade through the course of the year.

“We no longer expect Sterling to weaken versus the US Dollar but for it to consolidate around 1.25. This partly reflects the change in our US Dollar view. Moreover, we think that most of the hard Brexit expectations are already reflected in the price,” says Boele.

Morgan Stanley are also prominent believers in the view that Sterling has absorbed the majority of its Brexit negativity and they argue that the Pound is now cheap and is therefore ripe for picking.

Inflation Could Settle the Dispute

What is certainly of interest to us at this juncture is the future path of UK inflation and how the Bank of England will react.

The Pound jumped higher against its main rivals on news that UK prices have risen faster than anticipated in February 2017 - something that has lead to heightened expectations that the Bank of England might have to start raising interest rates.

Headline inflation for January read at 2.3%, well ahead of the 2.1% figure analysts had been expecting.

This confirms that inflation has breached the Bank of England’s inflation target for the first time since 2013.
The Pound leapt higher on the result as markets rushed to bet that the Bank will now have to consider raising interest rates.

At their March meeting it was shown that there were some members of the Bank's Monetary Policy Committee who felt the time had come to start considering raising interest rates.

News that inflation is pushing higher will only embolden this view.

"February’s CPI figures will have done little to reassure those MPC members who have recently become more concerned about higher inflation," says Ruth Gregory, UK Economist at Capital Economics.

We would normally argue the Bank will ignore that element of inflation that has been brought about by the decline in Sterling and global fuel prices as it would ultimately prove to be temporary 'one-off' hit.

BUT, much of the inflationary pressures reported today are being generated by economic activity that the Bank would likely consider acting on - core inflation rose by more than had been expected, from 1.6% to 2.0%.

This is that 'organic' inflation that is generated by a growing economy and wage growth which the Bank can control.

"As a result, the future path of inflation could be a little higher than both we and, more importantly, the MPC expected," says Gregory.

If the Bank starts raising rates, then we can almost certainly draw a line under the Pound's run lower.