7% Decline in Pound-to-Euro Rate Forecast for 2018 say UBS Eyeing UK's Trade Deficit

A growing imbalance in the UK's trading position, combined with Brexit uncertainty, are likely to be the twin evils responsible for an extension of Pound Sterling's decline.

Global financial services giant UBS have released their latest foreign exchange forecasts which show expectations for the Pound to weaken a sizeable 7.0% against the Euro in 2018.

Currency strategists at the Swiss bank see the Pound weakening substantially next year mainly because of a change in the dynamics surrounding the UK's widening deficit in traded goods.

The call comes ahead of the latest update on UK trade statistics from the Office for National Statistics which show the country's trade balance at £-11.25BN in September; confirmation that the UK imports considerably more than it exports. 

This imbalance translates into greater demand for the foreign currencies needed to purchase those imports than for the corresponding Sterling needed by foreigners buying UK's exports - the imbalance ought to be reflected in a weaker Sterling exchange rate, purely as a result of the law of supply and demand.

Yet it isn't, because the UK attracts inflows of foreign exchange from investors while UK investments oversees also yield a supply of inbound foreign exchange which adds an upward force on the value of Sterling.

The risk for the Pound is that this inflow of capital from investors is compromised at some point leading to an adjustment lower in the exchange rate - one of the key fears associated with Brexit is that the UK ceases to be a destination for foreign investment which would deprive Sterling of a much-needed source of support.

The Pound Could be 20% Overvalued

Despite the sizeable decline in Sterling following the 2016 EU referendum, analysis suggests the falls might still be too shallow.

To determine where the Pound should be trading financial analysts deploy a number of financial models to gauge where fair-value lies with the assumption that the currency will ultimately head there on a long-term basis.

According to one model at UBS which takes into account at the country's trade situation, at current market rates, Sterling is almost 20% overvalued, suggesting a large downwards correction in the exchange rate is due.

In fact, according to FEER, the Pound is the most overvalued currency in the G10.

Using the same model UBS Strategist Lefteris Farmakis estimates that the Euro is actually undervalued to the tune of 19% - the same amount as the Sterling is overvalued.

Assuming these currencies move closer to their fair-value estimates over time, the Pound is forecast to weaken whilst the Euro to strengthen, implying a considerable fall in GBP/EUR.

"Brexit and the UK's external imbalances have been central to our negative view on sterling for a while. Our FEER model screens Sterling as c. 20% over-valued in TWI exchange rate (Trade Weighted Index - an overall measure of Sterling value) terms even after the substantial drop since the Brexit referendum, as the UK current account has yet to correct to more sustainable levels," says UBS Strategist Lefteris Farmakis.

So What's New?

An imbalance in trade has always been a feature of the UK economy so why is it likely to be more of a factor now?

The answer is that previously the deficit was offset by a combination of a surplus of the balance of traded services (as opposed to goods) and a surplus in the flow of cash - or income account as economist call it - back into the UK.

"Substantial revisions in the income account included in the Q2 Balance of Payments release imply a larger gap to more sustainable current account levels than previously estimated."

i.e. the adjustment the Pound must make to compensate for a fall in foreign exchange inflows is actually larger than had previously been assumed.

Bank of England Won’t be Able to Help

The level of interest rates is a major driver of currency valuation and these are set by the Bank of England (BoE).

Higher interest rates strengthen the Pound because they lead to greater inflows of capital from foreign investors drawn by the promise of higher interest earnings.  

One argument against Sterling falling is that the BoE will continue raising interest rates and this will push up the value of the Pound.

But Farmakis is skeptical of this because he sees the current bout of inflation as primarily caused by the weak Pound and not domestic inflation.

"The Bank of England will not come to the rescue," he says because the inflationary effects of the weak Pound are already wearing off. The fall in value of the Pound lead to a rise in import costs which in turn lifted overall prices helping take UK inflation up to the 3.0% mark reported in September.

The Pound has risen notably from its October 2016 lows and this is feeding through and dampening inflation. The Pound-to-Euro exchange rate has risen from a low of 1.0746 to current levels at 1.1280 while the Pound-to-Dollar exchange rate has risen from 1.2589 recorded in June to current levels around 1.3138.

Therefore, faced with moderating inflation the BoE will soon have little reason to continue raising interest rates and deprive the Pound of much-needed support.

"Importantly, the BoE's recent hawkish shift does not change our bearish view for Sterling. This is because the reasons behind this shift are shaped by currency—induced inflation and lower potential growth rather than improving fundamentals, as highlighted in BoE Governor Mark Carney's speech at the IMF," says the UBS strategist.

What UBS make of the Bank of England’s expectations for higher wages in the UK in 2018 - as per their latest Agents report - is not dwelt on. But we argue that if pay-rises in excess of 3% are indeed delivered, the Bank will likely be facing domestically-generated levels of inflation that not only justify the November 2 interest rate rise, but advocate for subsequent interest rate rises.

This is a key risk to the negative view held by UBS we believe.

Underpining the entire bear-case at UBS is Brexit which is expected to ultimately have a dampening effect on UK growth which inturn impacts on the country's ability to attract investment and stimuluate pay growth which in turn generates the inflation the Bank of England is looking for.

UBS Forecasts for the Pound vs. Euro

UBS's forecast Sterling will fall by approximately 7.0% between now and the end of 2018, leading to a forecast exchange rate of 1.0455 in the Pound-to-Euro exchange rate and 0.95 in the Euro-to-Pound exchange rate.

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