British Pound Outlook Could be Sweetened With Brexit Fudge by Year-end, Capital Economics Says

- GBP faces bumpy ride in 2020, Capital Economics says.

- As Brexit negotiations address future trading relationship.

- But "fudge" could sweeten outlook for GBP by year-end.

- Enabling step-change in trading relationship to be avoided.

- And threat of an 'Australia deal' Brexit to fall by wayside.

- If BoE avoids a rate cut in 2021, GBP could rise further.

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The British Pound faces another rollercoaster ride this year as the Brexit saga opens a new chapter but it's still likely to recover further from the lows seen in 2019 and the outlook could even be sweetened with Brexit "fudge" by year-end, according to forecasts from Capital Economics.

Pound Sterling has recovered its footing against the Dollar and Euro this week following a volatile start to 2020 although with negotiations over the future trading relationship with the EU set to get underway from March 03, the path ahead for the British currency is expected to be a bumpy one.

"As the negotiations between the UK and the EU will probably be tough and long, 2020 is likely to prove to be another bumpy year for the pound. But sterling could still surprise on the upside later this year and in 2021," says Paul Dales, chief UK economist at Capital Economics. 

Both sides set out their opening positions for the talks earlier in February, with Prime Minister Boris Johnson extolling the perceived benefits of regulatory and legislative independence while seeking to reframe the dreaded 'no deal' Brexit as an 'Australia deal Brexit'. This was as the EU pitched for a status-quo style relationship and more time before the talks have even begun.

For Sterling, this made an ugly conclusion to act one of the new chapter in the EU exit saga, with the Pound-to-Dollar rate undergoing a steep decline from the highs seen at the end of January. The Pound-to-Euro rate, meanwhile, has consolidated in a sideways range because the single currency has itself ceded ground to the greenback, owing to a worsening economic situation in Germany.

Above: Pound-to-Dollar rate shown at 4-hour intervals alongside Pound-to-Euro rate (black line, left axis).

"We doubt the pound will rise much as long as there remains the possibility of the UK trading with the EU on WTO terms at the end of the year. Indeed, in that scenario, sterling could drop significantly, possibly to $1.15," Dales writes in a research briefing. "Nonetheless, we still think that sterling will end the year at $1.35, up from $1.30 at present as the UK and the EU agrees some sort of fudge that avoids a step change in the UK’s relationship with the EU in 2021."

The end of June marks a European Council deadline for Boris Johnson to request an extension of the 'transition period' the UK entered after its technical Brexit on January 31, and with Downing Street seeking a complete break with the current order as the EU stalls for time, market focus is quickly coming to bear on the deadline. 

Johnson says he won't entertain an extension, although he also said the same thing about October's Article 50 deadline while few if any forecasters seem willing to take him at his word. And whether or not he does eventually go for an extension could prove to be the difference between an 'Australia deal' Brexit and continued tariff-free trade with EU countries, as well as whether the Pound-to-Dollar rate ends the year at 1.15 or 1.35.

"Meanwhile, judging by the net-long positions now held in sterling, investors have already become much more positive about the pound. So sterling is unlikely to receive another big lift from this source," Dales says.

Above: Pound-to-Dollar rate shown at weekly intervals.

"The shrinking interest rate differential between the UK and the US in 2021 suggests that sterling could jump to $1.40 by the end of that year," Dales says.

Capital Economics forecasts the economy will grow fast enough for the Bank of England (BoE) to avoid an interest rate cut this year, which is expected to lift the Pound into year-end in part because investors have already wagered heavily the BoE will cut Bank Rate to 0.50% in 2020. Pricing in the overnight-index-swap market implied on Wednesday, a December 17 Bank Rate of 0.48%, suggesting investors believe a 2020 rate cut is a certainty.

However, the London-headquartered consultancy also argues that if "some sort of" Brexit-related "fudge" leads to a further ebbing of uncertainty over the UK's future trade relationship with the EU once into 2021, the BoE might actually lift interest rates at some stage next year. And given markets are in no way prepared for rate hikes any time soon, such a move from the Monetary Policy Committee could lift the Pound even further next year. 

"Since we expect the US dollar to appreciate against most currencies over the next couple of years as the US economy performs better than elsewhere, sterling will probably rise by more against other currencies. Against the euro we expect it to reach €1.29 by the end of 2020 and €1.33 by the end of 2021," Dales adds. "The negotiations over the UK’s new relationship with the EU will be tough, bumpy and long. And the risk that nothing is agreed should not be ignored. But the most likely scenario is that a fudge or compromise prevents a big change in trading arrangements."

Above: Pound-to-Euro rate shown at weekly intervals.