GBP/EUR Rate Now 4% - 20% Undervalued According to Various Models

Pound Sterling's unanswered four week fall against the Euro leaves it looking increasingly undervalued on various measures, meaning that even the most dire of Brexit-related outcomes is now already reflected in the exchange rate.

Just how much more selling pressure can be sustained?

Despite Sterling's undervaluation, there remains little consensus amongst analysts as to when the currency might recover, particularly against the Euro which is also widely held to be undervalued.

Sterling has fallen by 2.55% against the Euro in the last week alone, to change hands at a low of 1.0845 on Wednesday, August 23.

The Pound to Euro exchange rate has fallen by 7.49% for the year to date and is more than 20% lower from the 1.3157 level it traded at in final hours of June 23, 2016. The current 1.0850 pound to euro rate is equal to a EUR/GBP rate of 0.9215.

But there are persistent concerns being expressed that the currency might be heavily oversold at current levels, with bucket-loads of a worst-case-scenario Brexit outcome being already discounted.

“A very bumpy ride out of the union is already priced in,” says Andreas Steno Larsen, an analyst at Nordea Markets.

Larsen says, in a research note, that fundamentals of the U.K. and eurozone economies mean fair value for the EUR/GBP pair is somewhere around the 0.8200 pence to 0.8400 pence level.

This gives us a GBP/EUR at 1.22-1.19.

To get a sense of how out of kilter the exchange rate is, consider that the 1.0917 spot price of Tuesday, August 22 marks a “2 standard deviation event”. A Pound to Euro rate at parity of 1.00 would be a three-four standard deviation event, a highly improbable outcome in financial-risk jargon, according to Larson.

Analyst Petr Krpata at ING Bank N.V. says August’s persistent and gradual GBP/EUR decline is "largely risk premium driven" with the current short-term mis-valuation being worth c.4%.

But, according to ING's medium-term BEER valuation framework, GBP/EUR is undervalued by "a remarkable 20%," says Krpata.

Neil Dwane, global strategist at Allianz Global Investors is also of the opinion that Sterling is undervalued by a sizeable chunk.

"We also think the Pound is undervalued, by about 10-12%," says Dwane in an interview with Bloomberg. However, he warns believe the Pound can get even cheaper on the Brexit dynamic, particularly as market positioning is not yet at extreme levels.

Looking ahead, the analyst says there seems to be no near-term catalyst that will likely change the recent trend of GBP weakness that will allow the currency to find a fairer valuation.

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Urgency Being Injected into Brexit Debate, But the Pound Isn't Listening

The Pound is under pressure as liquidity on global foreign exchange markets increases as traders return to their desks from their summer breaks and accelerate existing trends.

The ongoing appreciation in the Euro against the Dollar appears to have caught up with the Pound; note EUR/USD is up 12% this year, the EUR/GBP is up 8%. So this could be a game of catch-up.

But concerns over Brexit and a slowing economy are undermining the Sterling side of the equation. 

the so-called red lines set by both the U.K. government and the European Union, during the early stages of Brexit negotiations in Brussels remain in place and concerns over a disruptive exit from the EU in 2019 appear to be well entrenched.

Fault lines have been confirmed by the release of the UK's position papers ahead of further negotiations, but we have learnt that the UK are willing to shift in order to push ahead with negotiations.

“The release of yet another Brexit paper by the UK government would highlight that the officials will be pragmatic and soften their stance on hitherto ‘red lines’ like the power of the European Court of Justice in the UK in order to speed up the negotiation process,” says Valentin Marinov, a strategist at Credit Agricole.

Markets are concerned that both sides won’t arrive at an agreement before exit day in March 2019, an outcome that would place trade between the UK and EU under WTO rules.

Many analysts believe such an outcome is increasingly unlikely; evidenced by the UK’s publication of a formal negotiating stance ahead of the next round of negotiations.

Possible concessions from the U.K. government over not just its red lines, but also the likely timeframe over which Brexit is implemented, might act as a catalyst for some stability in the Pound to Euro exchange rate.

“We would argue that at least the UK now appears to be acting with greater urgency in order to provide the basis for the EU having a better understanding of the UK’s stance and what the UK is seeking,” says Derek Halfpenny, European Head of GMR at MUFG.

The EU has been calling for clarification on a number of issues and now ahead of the 3rd round of negotiations which commence in the week starting August 28.

There have been four position papers released by the UK this week, the latest out on August 23 covering a framework for “cross-border civil judicial cooperation”

The UK Government conceded on Wednesday, August 23 that European Union law will influence the U.K. long after Brexit, the move has been described as a climbdown aimed at accelerating divorce talks that seemed to be initially accepted by eurosceptics in her Conservative Party.

Seven months after May declared the U.K. would "take back control of our laws and bring an end to the jurisdiction” of the European Court of Justice, her government will say in a position paper on Wednesday that it’s now seeking to bypass just the body’s "direct jurisdiction."

The move has been seen by some as a necessary softening of a previous red line in order to push talks forward.

Not Convinced the Pound will Remain Under Pressure

J.P. Morgan have cut the probability of a hard-Brexit, which is defined as an exit where the U.K. trades with the EU according to WTO rules, from 25% to 15%.

“The long-term risk to GBP from a disruptive Brexit has diminished as most players in the government now accept the need for a transitional deal that will ensure very little changes on the ground for a handful of years after 2019,” says Paul Meggyesi, a strategist at J.P. Morgan.

Technical analysts at the US baking giant warn that “the rally phase for EUR/GBP has been quite resilient over the past several months, but we sense a corrective phase is close.”

Credit Agricole are meanwhile concerned Sterling is heavily undervalued at current levels.

“We believe that some cautiousness may be warranted, however, given that the latest bout of GBP-weakness has brought it into undervalued territory against both EUR and USD,” says Marinov.  

MUFG’s Halfpenny agrees:

“We are not convinced that the Pound will remain under downward pressure due to political uncertainties ahead of a fresh round of Brexit negotiations and the return of parliament after the summer recess.”

It's not just the fundamental analysts suggesting Sterling is oversold, technical studies suggest the same.

“The relative strength index (81%) warns that the euro may have rallied too fast in a short period of time and the overbought market condition could necessitate a short-term downside correction,” says Ipek Ozkardeskaya, an analyst with London Capital Group.

But be warned, buying the Pound in anticipation of a recovery is tantamount to catching a falling knife. Be cautious and wait for signs of stability.

"While EUR/GBP is looking overbought, the trend looks like a runaway train and it’s difficult to go against it," says Kathleen Brooks, an analyst with City Index.

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Despite the discount carried by the currency, there is near-unanimity in projections that the outlook for Sterling remains bleak going forward.  

Strategists at UniCredit see Brexit negotiations hitting multiple stumbling blocks over the months ahead, ranging from the so-called Brexit Bill to an eventual deal over citizens rights, which could mean it is December time before any form of progress is made.

“The resulting uncertainty will lead the BoE to leave its monetary policy stance unchanged throughout the period of Brexit negotiations...We see further upside for EUR-GBP,” says UniCredit FX strategist Tullia Bucco.

Sterling’s Decline Pauses, Could be Profit-Taking

Sterling decline appears to have taken a breather on August 24, despite poor data.

EUR/GBP came slightly off the recent top around 0.9235. Cable returned north of 1.28.

The UK data couldn’t explain the pause in the Sterling decline, as the UK data disappointed on the headlines. However, we note that under the hood there were signs that the UK economy would print better figures in the second half of 2017, which could helpe explain the resillience. 

There was no high profile news from the Brexit negotiations and an element of profit-taking on the recent run higher in the Euro might explain the relief afforded to Sterling.

"The market apparently found itself a bit too much sterling short and needed some corrective action. EUR/GBP trades currently in the 0.92 area. Cable is changing hands in the 1.2820 area. Today’s move didn’t change the global technical picture for the UK currency though," says Piet Lammens an analyst with KBC Markets in Brussels.