British Pound to Rise Vs Euro in 2018 as UK Heads for “Softest of All Possible Brexits"

The softest of all Brexits could mean political risk comes off the table in 2018, leaving FX markets to focus once again on economic growth, inflation and interest rates.

The Pound will rise against the Euro in the year ahead as markets awake to the realisation the UK is headed for the “softest of all possible Brexits”, say strategists at BMO Capital Markets, the investment banking unit of Bank of Montreal.

A shift toward a more watered down exit from the European Union will lead Sterling, which is cheap according to BMO, to begin trading according to its fundamentals once again.

“In combination with a weak USD, we think 2018 will pave the way for the ‘softest’ of all possible Brexits and a 1-2-year transition,” says Stephen Gallo, head of foreign exchange strategy at BMO Capital Markets.

Complications over the Northern Irish border and the threat of a snap election, which the government might lose, could mean Prime Minister Theresa May eschews a full exit from the European Union.

At the minimum a "soft Brexit" is likely to mean the UK stays within the regulatory and legislative orbit of the European Union institutions in return for continued access to the EU's single market, or in other words, an absence of non-tariff barriers to trade. 

“Although an orderly ‘hard Brexit’ in 2018 would be a better outcome for the UK, the government lacks the time and political capital to implement one,” Gallo adds.

The UK’s general election in June 2017 saw Prime Minister Theresa May and her party convert a 19 point polling lead into a hung parliament.

“We believe that the critical debate over the UK’s post-Brexit relationship with the EU will take place during the transition period,” says Gallo, in BMO’s 2018 outlook.

Consensus among observers is the electoral disaster has left the government in fear of another vote and vulnerable to pressure from the pro-European Union opposition, the Labour Party, to pursue a “softer Brexit”.

“Consequently, we see UK snap election risks cooling in the year ahead before rising again in late-2019/early-2020,” notes Gallo.

The UK is scheduled to depart the EU on March 29, 2019, the date when the two year Article 50 period will come to an end. Brexit negotiators have so far agreed to begin discussing trade and transition to a new relationship in early 2018.

Lawmakers have created a legislative mechanism, in the form of a recent amendment to the European Union Withdrawal Bill, that will allow them to delay the UK’s March 2019 departure from London.

However, any extension of the Article 50 period will require the blessing of Brussels, according to the Treaty of Lisbon.

“Therefore, we believe that the GBP will start to respond to a number of fundamentals in 2018 which suggest that the currency is still quite cheap,” says Gallo.

The Pound remains 14.29% cheaper against the Euro than it was on the day of the Brexit referendum, after having fallen from 1.3148 on June 23, 2016.

Against the Dollar, Sterling is a mere 9.4% lower after having taken back 8.5% of its loss during 2017 thanks to recent weakness of the US currency.

Meanwhile, since the referendum, the UK economy has performed better than was expected by almost all forecasters. Economic growth was largely undisturbed during 2016, according to the latest figures, while the slowdown seen during 2017 has been relatively modest.

“Although we currently think the BoE will remain on hold until late-2018, the reasonably strong performance of the economy in 2017 and the acceleration in global growth suggest that the risks of a BoE rate hike before June are currently underpriced by the Overnight Index Swaps market,” says Gallo.

The Bank of England has raised interest rates for the first time in a decade, by 25 basis points to 0.50%, to address the inflation brought about by the devaluation in Sterling. Further rate hikes could also be on the cards, although opinions are divided over how soon they might come.

“Our conviction level on GBP strength in 2018 is moderate. The emergence of deep rifts within the government, a snap election and a disorderly ‘hard Brexit’ are all theoretically possible next year,” warns Gallo.

“We would abandon our constructive view on the GBP in the event of a snap election, given the current tightness of the polls.”

Recent opinion polls have shown the governing Conservative Party and the opposition Labour Party vying with each other in a neck and neck race for first place. Labour have at times held the lead over the ruling Conservatives.

A profligate fiscal approach and populist promises such as the June 2017 electoral offer to write off all student debts nake it is difficult to tell which should be seen as a greater long term risk to the UK economy, a so called “hard Brexit” or a Labour Party government.

There have been few detailed forecasts of what a Labour government might mean for the economy although analyst commentary to date has been far from flattering.

“However, in the event of a disorderly ‘hard Brexit’, we think the likely decline in GBPUSD to the $1.15/1.20 area would be a good long-run buying opportunity,” says Gallo.

The BMO Capital Markets team forecast the Pound-to-Dollar rate will rise back to 1.40 within the next 12 months, which would see the Pound having recovered more than half of its post-referendum loss.

“In EURGBP, our preference would be to sell rallies and we look for GBP rebound to the 0.8600 area in 9M,” says Gallo. “We see little value in being short-GBP north of 0.8900 in EURGBP.”

The 0.8600 pence target that Gallo and the BMO team have for EUR/GBP over the next nine months corresponds to a Pound-to-Euro rate of 1.1627.

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