Pound a Buy, Euro a Sell: S.E.B's 'Top Trade' for 2018

2018 should see Brexit talks between the U.K. and E.U. steadily progress, and this will lead to a strong upswing in an undervalued Pound-to-Euro exchange rate.

A breakthrough in Brexit negotiations is likely in 2018, says Richard Falkenhall, Senior FX Strategist at Skandinaviska Enskilda Banken A.B. (S.E.B.), and this will see the Pound recover in the region of 11% against the Euro.

S.E.B. have released their top trades for 2018 - a document setting out where the greatest opportunities to profit in the market lie; and a recovery in the value of Pound Sterling relative to the Euro appears to be a high conviction expectation.

The call comes as the Pound is seen rising on news that talks are likely to progress to the issue of trade and the future relationship as early as January thanks to reports progress has been made on the sticky issues of the financial settlement bill and the Irish border.

Falkenhall tells clients he believes progress in negotiations should continue and the U.K. will leave the E.U. with a trade agreement because neither side will want the apocalyptic economic fallout associated with a no-deal scenario.

Although the progress of negotiations to date has been slow, these are still early days, and Falkenhall thinks that as the Brexit deadline in March 2019 approaches, a sense of urgency will ensue, and the two opposing camps will give ground so as to eventually broker a trade deal.

"Political negotiations of this kind are often conducted in such a way, with last-minute talks enabling each side to justify the outcome while arguing they did everything possible to reach the best possible deal," says Falkenhall.

Pound Well Below Fair Value

Studies conducted by S.E.B. show Pound Sterling to be trading well below the level it would normally be expected to be at because of the anticipated negative economic consequences of a no-deal Brexit.

Falkenhall estimates the Pound is about 16% undervalued - as would be expected under current economic conditions - solely due to negative Brexit fears.

Although Sterling has clawed back a considerable amount of its post-referendum weakness versus many of the G10 currencies in 2017, it has weakened by about 3.5% versus the Euro.

It is against the Euro, reasons the S.E.B. Strategist, that there is the most upside potential, therefore, in the event that a deal is brokered and Brexit risk fades.

"Given the size of the risk premium, a breakthrough in negotiations would most likely trigger a substantial GBP recovery in 2018. Partly, this may even happen in December if exit talks progress sufficiently to open up negotiations on the future relationship between the EU and UK," says Falkenhall.

Above: If it were not for Brexit the Pound-to-Euro exchange rate would be as high as 1.33 (EUR/GBP @0.75)

The S.E.B. Strategist recommends selling EUR/GBP at 0.9000 down to a target at 0.80000, on expectations of a breakthrough in trade talks - or buying GBP/EUR at 1.1100 and holding to a target at 1.2300.

The risk to this trade is that talks remain deadlocked but given how much the Pound has lost already it cannot lose significantly more, argues Falkenhall, limiting downside risk substantially.

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Sterling rises on Signs of Brexit Progress

The British Pound trades higher as reports of further progress on outstanding issues in the first stage of Brexit negotiations are met by renewed buying interest.

Markets bid the Pound to fresh tw-month highs against the Dollar and multi-week highs against the Euro on Thursday, November 30 on reports that the question of the Irish border appears to have been dealt with to an extent which will allow Brexit talks to progress to the next stage.

The Times reports British officials tabled proposals this week to avoid a hard-border in Ireland that could unblock the last remaining major obstacle to a deal.

The Pound will have liked the observation that "EU leaders are preparing to offer a two-year Brexit transition deal as early as January after negotiators said that they were close to a breakthrough over the Northern Ireland border."

"GBP soared after the Times reported that negotiators are close to a breakthrough on the difficult problem of the Irish border. If the two sides agree, E.U. leaders reportedly could offer Britain a two-year transition arrangement as early as January. The news triggered a lot of stops that pushed the currency higher. This would be tremendously bullish for Sterling," says Marshall Gittler at ACLS Global.

“After sufficient progress on withdrawal we will open the next two phases of negotiations, first of all on a transition period and then on the future partnership,” a senior EU negotiator told the Times. “A transition deal will be ready in principle for January.”

Progress on the Irish border follows news that both the U.K. and E.U. had arrived at a figure that would settle the U.K's outstanding financial liabilities once it leaves the Union.

The two sets of news have allowed the Pound-to-Euro exchange rate to advance towards 1.1368 which represents the top of its September-November range.