British Pound 20% Undervalued vs. Euro say SEB

© kasto, Adobe Stock

Analysts believe Pound Sterling will ultimately become "much stronger" against the Euro than it is today, but patience is required.

The Pound will eventually reverse its undervaluation relative to the Euro, according to a group of Swedish economists, although now is not the time for speculators to pile into bets favouring a recovery of the British currency.

At 1.1260, the Pound-to-Euro exchange rate is still 14% below the 1.3100 level it was at on June 23rd, 2016, before the EU referendum result became known.

It has been trapped in a range spanning the 1.1200 to 1.1500 threshold for the last three months, traversing back and forth from each end of the range like a ball in a proverbial tennis match.

Above: Daily graph showing the two key ranges dominating GBP/EUR. Note however the gentle uptrend in place since the September lows were rejected.

However, analysts at Skandinaviska Enskilda Banken (SEB) - the Swedish multinational banking giant - say the exchange rate is 20% undervalued when current prices are compared with their estimate of long term fair value for the EUR/GBP exchange rate.

The reason for the undervaluation is the risk premium posed by Brexit, but steady progress in negotiations should lift some of the fog of uncertainty and allow Sterling to extend its recovery.

“Ultimately, probably neither the EU nor the UK can afford to allow negotiations to fail without a deal. Consequently, we retain a positive view expecting both a trade deal and transition period to be agreed before the UK’s exit in March 2019,” says Richard Falkenhäll, a senior FX strategist at SEB.

Negotiations have been fraught with risk for markets so far, with horse trading over Brussels’ earlier demands of a “divorce bill” and “sufficient progress” on agreements relating to citizens rights and the Northern Irish border both sinking Sterling on repeated occasions in 2017.

More recently, the Pound was knocked around when Brussels negotiator Michel Barnier told the media that a deal on transitional arrangements is “not a given” if Prime Minister Theresa May objects to Brussels’ demands.

Brussels wants the UK to obey all current and future EU laws when in transition, which had prompted grumbling from London, although a more contentious demand for powers to suspend UK access to EU markets if a breach of EU rules occurs has recently been dropped.

“Simply put, disagreements and a process in which nothing falls into place until the very end (October) of discussions would seem to reflect the nature of political negotiations. While obviously we expect an outcome that suggests a much stronger GBP than today, it is probably too early to buy the UK currency just yet,” says Falkenhäll.

Negotiators have until the March 22 European Council summit to agree on the terms of a transition period in order for it to be approved by heads of state from across the European Union at the summit.

Only once a transition is agreed, can negotiators then begin to focus on the future trading relationship.

A transition period ensures the status quo remains in place for a so-far unconfirmed period of time after March 2019. The government says it is necessary to ensure companies have enough time to prepare for any changes that will take place after the UK leaves the EU.

SEB believe that any significant breakdown in talks should however allow the Euro to test its 2016 highs against the Pound once more.

“While potentially we may have seen a long-term EUR/GBP peak last year, levels slightly above 0.90 are well within reach if it becomes clear major disagreements have been encountered,” says Falkenhäll, referring to a level of EUR/GBP that translates to a Pound-to-Euro rate at 1.11.

Yet amongst the various rounds of Brexit negotiations, and the associated volatility in foreign exchange markets, Sterling has the tailwinds of relative interest rates and monetary policy on its side which advocate for a higher fair-value level.

"Being significantly undervalued the GBP will appreciate once a Brexit deal is concluded and on further rate hikes by the BOE both this year and next. Still, since that point has not yet been reached, we recommend waiting to buy Sterling at better levels above 0.90 against the EUR," says Falkenhäll.

The Bank of England raised its interest rate for the first time a decade back in November taking the basic bank rate back up to 0.50% which allowed the Pound to end 2017 on a strong note. The Bank has recently warned markets that it will raise the bank rate faster than previously guided if the UK inflation outlook evolves in line with its latest set of forecasts and markets are currently betting on a May interest rate rise.

UK inflation remains persistently high amidst a combination of rising oil prices, growth in wages and the legacy of Sterling's previous decline that came in the wake of the EU referendum.

UK consumer price growth rose to 3.1% in November and has remained stubbornly at the 3% level ever since. More importantly the crucial measure of core inflation, which removes volatile food and energy prices from the goods basket, is still rising.

In order to return inflation toward the 2% target over the coming years, the BoE has committed to a steady cycle of interest rates rises and many analysts who see a stronger Pound on the horizon cite the Bank as a key driver of such expectations.

“Our core long-term valuation recommendation is to be either neutral or long the GBP. Given the two opposing forces presently at work, we prefer to buy the UK currency on rallies by EUR/GBP above the 0.90-level triggered by Brexit concerns,” Falkenhäll concludes.

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