Pound Sterling Forecasts 2014: The View from Lloyds Bank

It has been a volatile month for the UK exchange rate, with strong gains over much of January largely reversed over the past two weeks. Since hitting a 4 1/2-year high above $1.66 last month, GBP/USD has fallen back to around $1.64. This seems to have been driven in part by the Fed’s decision to cut its monthly bond purchases by a further $10bn at its January FOMC meeting, as well as an associated flight to quality out of emerging markets into the US dollar.

At the same time, UK economic data have been more mixed and there has been growing speculation that the MPC will play down the prospects of a rate rise by adjusting its forward guidance in its upcoming Inflation Report. Similarly, GBP/EUR has given back last month’s gains, falling from a recent high of 1.2250 to end little changed below 1.2050. The recent fall highlights the ongoing challenges still facing the pound. We target GBP/USD at $1.52 and GBP/EUR at €1.22 by year end.

The dollar is little changed over the last month. It is modestly lower versus the yen but has seen little movement against sterling and the euro and is modestly higher versus other G10 currencies. Fluctuations in currency markets have been dominated by uncertainty in emerging markets.

This has encouraged a flight to “safe havens”, which has supported the dollar. US economic news has been mixed. Preliminary Q4 GDP data showed the economy finished 2013 on a fairly strong note. However, payrolls disappointed in January for the second successive month. The FOMC tapered by a further $10bn at its January meeting but seems a long way from raising interest rates. Overall, we still think the US is ahead of other countries in the economic cycle and that relatively strong growth, and higher interest rateswill lead to further dollar gains.

The euro has been in a range against the USD, with domestic and external developments having limited sustained impact. EUR/USD is back above 1.3650 at the time of writing, despite euro area inflation surprisingly falling to 0.7% in January and rising speculation of further ECB easing. One key reason is the gradual recovery in euro area activity, while the continuing fall in peripheral bond yields signals improving general confidence.

However, there remain significant underlying structural frailties. The European Parliamentary elections and banking system assessment are two key risks in 2014. Prospects for the euro are also undermined by less favourable relative outlooks for euro area growth and interest rates, particularly against the US. We expect stronger US economic data and rising interest rates to underpin the dollar in the year ahead. EUR/USD is forecast 1.25 at end 2014.

The yen has risen sharply over the past month, touching 101 versus the USD and appreciating against both sterling and the euro. The rally has been driven by international factors, in particular the “risk-off” sentiment generated by uncertainties in emerging markets, which has resulted in a flight to ‘safe haven’ currencies.

In contrast, domestic economic fundamentals are little changed. Retail sales fell sharply in December, but industrial production rose and business surveys show rising optimism. We expect economic growth to remain buoyant ahead of the consumption tax increase in April, but what happens after that remains uncertain. We believe further monetary policy easing will be required in the second half of the year. Consequently, while the current uncertainty may support the yen short term, we expect a fall to 108 versus the USD by year end.

See Bank of America's latest forecasts on the Aus Dollar, published today

The AUD fell in late January, reaching a 12-month low below 0.87 versus the USD. This was driven by concerns about commodity prices and whether slower growth in emerging markets, particularly China, would hamper Australian exports. The AUD rebounded in early February, after the RBA abandoned calls for further currency depreciation, at its February policy meeting. However, while the RBA has signalled that monetary policy is on hold for now, it is premature to conclude that the next move in interest rates is up and potentially before year end.

The economy continues to face a number of headwinds that will likely require very loose monetary policy for some considerable time. Moreover, any significant rebound in the AUD will likely see the RBA reassert its easing bias. As a result, we expect the AUD/USD to fall to 0.85 by end 2014.

The CAD has continued to fall over the past month, approaching 1.11 versus the US dollar. The latest depreciation has primarily been driven by international factors. In particular, the uncertainty around emerging markets has resulted in a flight to more ‘safe haven’ currencies. Commodity currencies, like the CAD, have also been hit by doubts over Chinese economic growth and its impact on commodity prices. Canadian domestic conditions have been of little help to the “loonie”.

The BoC left interest rates unchanged at its latest policy meeting, but highlighted inflation was running below expectations. Consequently, a near-term rate cut cannot be ruled out. While the CAD may rebound, if global market conditions become calmer, relatively disappointing economic performance points to further depreciation versus the USD. We forecast USD/CAD at 1.13 at end 2014.

The NZD has slipped over the past month dragged down by the uncertain conditions in the currency markets. The RBNZ’s decision to hold interest rates at current levels at its January policy meeting may also have contributed to the sell-off, even though it repeated that rates are likely to rise sometime this year. The RBNZ remains concerned the NZD is overvalued and has suggested it is likely to fall over time. However, the high probability of interest rate hikes in 2014 should remain a support to the currency and points to appreciation in the effective rate. In particular, we expect a modest rise versus the AUD and the CAD.