Potential 7% Gains for Pound Sterling vs. Euro Over the Coming Year, but will Struggle Near-Term: Danske Bank

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- The Pound-to-Euro exchange rate to go back above 1.20 longer-term

- Any near-term bounce from Bank of England rate rise to be short-lived

- Bank of England to strike cautious tone this Thursday

The British Pound will see only limited gains from a Bank of England interest rate rise this week, according to analysts at pan-European lender Danske Bank, who are arguing that the currency will remain hamstrung by uncertainty until there is clarity around the UK's departure from the European Union.

However, an eventual Brexit deal that offers companies certainty over the parameters of the future relationship, as well as avoiding a disorderly exit, should eventually yield a 7% increase in the Pound-to-Euro exchange rate.

"The GBP has been one of the weakest performing currencies in the G10 space over the past month, as political uncertainty related to Brexit has outweighed the growing prospect of a rate hike from the Bank of England in August." We expect EUR/GBP to trade slightly lower going into the Bank of England meeting. However, given that the market almost fully discounts a rate hike, we expect any rally in the GBP to prove short-lived," says Morten Helt, a senior analyst at Dankse Bank, referring to the inverse of the Pound-to-Euro rate.

The Bank of England is widely expected by the market to raise UK interest rates to 0.75% on August 02, 2018 despite that consumer price pressures have fallen much faster this year than it or almost any economist had forecast.

UK inflation held steady at 2.4% in June when economists had been looking for the consumer price index to rise to 2.6%, given a double-digit increase in oil prices this year and has fallen from 3% in January 2018. Core inflation, which excludes energy and food items from the goods basket measured, fell from 2.1% to 1.9% in June.

BoE officials forecast in February, when the consumer price index was still at 3%, that it would remain above the 2% target until at least the first quarter of 2021. The BoE's mandate is to keep inflation at or close to 2% over the medium term while having regard for the labour market, which is a quasi-dual-mandate. Changes in interest rates are normally only made in response to movements in inflation.

Sterling outcomes for the August Bank of England meeting. We see a neutral/bearish GBP reaction as the #BoE will find it difficult to steepen the UK rate curve amid the obvious political headwinds. Tail risk of no hike would effectively pull the rug from under $GBP (#GBPUSD 1.28) pic.twitter.com/RrMBlJmhyz

— Viraj Patel (@VPatelFX) July 30, 2018

"While we still believe the Bank of England is too optimistic on the inflation outlook, it seems that Mark Carney and company are more concerned about overheating the economy," says Helt. "Like many other central banks around the world, the Bank of England believes in the Phillips Curve and thinks underlying inflationary pressure is increasing as the labour market continues to tighten."

Wage growth has remained tepid too, despite BoE statements in February that suggested it would pick up toward 3% later this year. UK wage packets grew by an average of 2.5% during the three months to the end of April, which is down from a peak of 2.8% back in February and exactly the same rate of growth seen during the three months to the end of December 2017.

"While we see the MPC delivering a 25bps rate hike at the ‘Super Thursday’ August BoE meeting, we think the potential for at least 1, if not 2, dissenters (Cunliffe and Ramsden) – as well as cautious rhetoric by Governor Carney in the post-meeting press conference – is unlikely to engender much hawkish spirit in either UK rates or the pound this week, not least as both markets remain dominated by the risk of a no-deal Brexit," says Viraj Patel, an FX strategist at ING Group.

With the merits of a Thursday interest rate rise put to one side, most analysts agree that a rate hike this week will do little to lift the Pound over the short-term. Neither Patel nor Morten's views are isolated or unique.

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Longer-Term Gains

"Longer-term, we still expect EUR/GBP eventually to trade lower driven by Brexit clarifications and fundamental valuations. We target EUR/GBP at 0.8650 in 3M, 0.8400 in 6M and 0.8300 in 12M," Helt writes, in a note to clients.  

Helt's forecasts therefore suggest the Pound-to-Euro rate will rise to 1.1560 by the end of October 2018, to 1.1904 by the end of January 2019 and to 1.2004 before the end of July 2019.

The UK is set to depart the EU on March 29, 2019 but it is far from certain whether this departure will be an orderly one.

October's European Council summit marks a soft deadline for progress in the talks as it is seen as the last viable opportunity for national leaders to approve a withdrawal agreement with enough time left over for it to be ratified in all parliaments across the European Union. 

Therefore this date could prove a trigger to a recovery in Sterling, provided clear signs of progress are provided.

The EU has agreed to Prime Minister Theresa May's "transition period" of nearly two years following the exit date, during which future trade ties are expected to be agreed, although this is contingent on UK politicians agreeing to all of the EU's demands in the withdrawal agreement.

Without an agreement on withdrawal there will be no deal on future economic ties so the UK will leave the EU on March 29, 2019 and default to trading with it on World Trade Organisation terms.

This would likely see Danske Bank's forecasts for a broad recovery in Sterling-Euro scuppered.

Prime Minister Theresa May set out her "Chequers plan" for Brexit earlier this month, which saw the PM abandon almost all of her "red lines" in the negotiations, prompting a wave of resignations from the cabinet, Department for Exiting the European Union and the Conservative Party.

Brexit-supporting MPs have claimed the PM's plan places the UK on track to leave the EU in name only and have threatened to vote it down when it comes to parliament.

Parliamentary and party protests over the PM's proposals have raised the spectre of a "Brexit deal" that too few within the UK parliament will be able or willing enough to support which, after its potential rejection in the House of Commons, could see the UK exit the EU without any agreement on withdrawal or the future relationship.

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