Pound to Breach 1.17 vs. Euro in 2018 if Transition Agreement Secured say BofAML

The Pound is forecast to endure a steady, if unspectacular, rise against the Euro over coming months should a transitional Brexit deal be secured.

Analyst Kamal Sharma at Bank of America Merrill Lynch Global Research argues that as the risks and uncertainty posed by Brexit negotiations fade, the British currency will revert back to its more traditional drivers.

And, this bodes for potential strength over coming months, particularly as the Bank of England gears up for a number of potential interest rate rises.

This is the second time we have heard from Bank of America Merrill Lynch Global Research this week - readers will recall we have reported that their technical analyst Paul Ciana expects Sterling to rise higher having broken some key technical barriers.

The technical and fundamental analysts in the same institution can often have differing views on the same exchange rate owing to the different approaches each adopts, but in this instance it seems both technical and fundamentals are rowing in the same direction. That said, Ciana's technical analysis does put his potential Pound-to-Euro exchange rate target higher.

According to Sharma, downside risks from the Brexit negotiations are now expected to have an increasingly benign influence over the Pound as the UK government is on course to deliver a so-called soft Brexit under almost all imaginable scenarios.

“The red lines that had been so forcibly set out and defended by UK officials at the start of 2017 have fallen by the wayside as the Prime Minister has attempted satisfy the competing forces within her own party in the aftermath of the June general election,” says Sharma in a briefing released in late January.  

We report these views in the wake of a dip in the value of Sterling owing to markets taking fright from a new development in the Brexit saga - this time involving the continued access of the UK's financial sector to the European market.

Reports suggest the EU will reject granting UK services a free trade deal, instead they will be looking to offer a free trade deal for goods - something that supports Europe as they have a trade surplus in goods with the UK.

The news, and Sterling's reaction, confirm the currency is still prone to headlines surrounding the negotiations.

That said, these headlines do not stem from official negotiations and markets appear inclined to look past the noise for now and assume the UK government is keen to strike a deal, even if it means bending to the will of the EU.

While this may not be to the taste of Brexiteers, the general rule of thumb goes that a softer Brexit makes for a stronger Pound, and much of the move towards a softer Brexit owes itself to the compromises the Government has to make in order to pass legislation through parliament.

An amendment to the EU Withdrawal Bill, forced through the House of Commons in late 2017 by the opposition and rebels from Prime Minister Theresa May’s own party, has been seen tying the government’s hands and preventing it from heading toward a “no deal Brexit”.

Amendment 9 requires that parliament be given a “meaningful vote” on the final deal, meaning it can send the government back to the negotiating table if it does not like what has been agreed by PM May.

When taken together with the European Council’s January 2018 claim that any so called transition agreement can be extended beyond the December 2020 end point, the UK can quite conceivable remain inside the EU in all but name until such time as a “soft Brexit” has been agreed.

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May's Leadership Could be a Worry for Sterling

“We think political risks still exist but believe they stem from the domestic politics given the government’s small working majority. The passage of the EU Withdrawal Bill has already highlighted the compromises that the government will likely have to make over the coming year as we enter into Phase 2,” says Sharma.

“We therefore think GBP is more vulnerable to doubts about the PM's leadership if markets believe it changes the current Brexit dynamic.”

Doubts over Prime Minister Theresa May’s leadership flared once again this week when the European Council unveiled its demands for the terms of any transition. Critics exist on both sides of the Brexit and Remain divide although little action to remove the PM has been taken to date.

“As the tail risks continue to fade, macro data and UK rate expectations have become more significant drivers for GBP in recent months particularly against the backdrop of significant GBP undervaluation,” says Sharma.

“We expect this trend to continue on our expectation that transitional agreements effectively put Brexit on the back-burner until definitive deadlines approach.”

Forecast for the Pound

Meanwhile, after a year of motoring along at a reduced speed, the economy could be on course to regain some more of its lost momentum in 2018 as inflation falls and the UK rides along on the coattails of the global growth upturn.

The consensus is for UK GDP growth to slow to 1.4% during 2018, from 1.8% in 2017, although some economists are claiming this is “too gloomy” a prediction and that growth should actually accelerate in the year ahead.

Capital Economics, a leading independent consultancy of economists, forecasts GDP growth of around 2% for the year.

Sharma and the BAML team flagged this week that UK growth typically has a high correlation with global economic growth, which is picking up pace rapidly.  

This explains why the gap between short term bond yields in the UK and the Eurozone has recently reverted back to levels last seen before the June 2016 referendum, according to Sharma.

In layman’s terms, that means investors expect UK interest rates will rise concurrently with international interest rates as the global economic upturn gathers pace.

“We think this is important against the backdrop of GBP undervaluation... On our view that transitional arrangements effectively kick the Brexit can down the road, this should allow GBP to exclusively focus on the business cycle which means a correction of its undervaluation,” Sharma writes, in a recent note.

The Pound remains 12.9% lower against the Euro when the rate of 1.1400 on January 31, 2018 is compared with the exchange rate of around 1.3000 that was seen on the night of the referendum. Sterling has all but reversed its post-referendum loss against the US Dollar.

“We think markets only require confirmation of a transition agreement and believe its announcement will pave the way for further GBP gains with EUR/GBP expected to trade towards 0.85 by year-end,” says Sharma, referring to a level of EUR/GBP that puts the Pound-to-Euro rate at 1.1764 before the end of 2018.

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