Pound Sterling is Running too Hot say Analysts in Wake of Eye-watering Gains against Euro and Dollar

- "GBP’s reach exceeds its grasp" - HSBC
- As GBP/EUR and GBP/USD hit new highs on Thursday
- Bank of America says further upside possible

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• Market rates at publication: GBP/EUR: 1.1625 | GBP/USD: 1.4160
• Bank transfer rates: 1.1400 | 1.3860
• Specialist transfer rates: 1.1544 | 1.4060
• More about bank-beating exchange rates, here

The British Pound's stellar gains in 2021 are not deserved say analysts at one of the world's most prominent investment banks,  who warn in a recent research note that a "nasty fall back to reality" might await.

The Pound has risen to multi-month highs against both the Euro and Dollar and is the top performing G10 currency of 2021, as a combination of factors converge to trigger a rebound from the lows of the Brexit period.

Some of the reasons include expectations for a vaccine-lead sustainable unlocking of the economy ahead of other major countries and reduced expectations for negative interest rates at the Bank of England. Aiding this sentiment is the removal of Brexit uncertainties and the boosting of Sterling reserves at international central banks.

But analysts at HSBC say the currency is trading well above levels justified by fundamental factors that should mean it is anchored lower.

"GBP’s reach exceeds its grasp," says Dominic Bunning, a strategist at HSBC in a recent briefing on the currency. "In our view that upward momentum is undeserved from a value perspective. The move in GBP has far exceeded that of other anchors which one would normally associate with currency outperformance."

The HSBC analyst cites three factors that make the Pound potentially overvalued:

1) "The UK’s economic recovery remains lacklustre compared to others. The HSBC UK activity surprise index is one of the few trending sideways, not up, showing that the economy is not outperforming expectations in the way the US or Eurozone are."

2) "UK forward rates have risen this year with negative rates being priced out, but the move has been largely in line with what has happened in other G10 rates markets, especially the US. As rate differentials are what should matter for FX, the rate move does not justify GBP’s significant rally."

3) "UK equities remain a laggard suggesting that it is not foreign equities inflows driving GBP outperformance."

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HSBC strategists recognise momentum behind Sterling as being powerful, but the currency will remain overstretched until the underlying fundamentals change for the better.

The Pound-to-Dollar exchange rate rallied to above 1.42 on Thursday while the Pound-to-Euro exchange rate breached 1.16.

At the time of publication the GBP/EUR has rallied 4.0% in 2021, with the GBP/USD going up 3.25%.

"Robert Browning once wrote “a man’s reach should exceed his grasp, or what’s heaven for?” For a currency, the danger in exceeding your grasp is not that you reach heaven but that you get a nasty fall back to reality when the momentum wanes," says Bunning.

The Pound registered fresh multi-month highs not just against the Euro and Dollar on Thursday, but also against the Franc and Yen with little to suggest momentum is about to fade, although HSBC are not alone in questioning Sterling's break-neck ascent.

Other analysts we follow say the rapid rally could be due a cooling-off given some technical signals are suggesting overbought suggestions.

"Sterling continues its stellar run, breaching 1.42 vs the USD and 0.86 in EUR/GBP. The latter is reported to be linked to option related selling. In light of the recent moves most Sterling crosses are extending further into overbought/oversold territory, suggesting that a degree of caution may be required near term," says Jeremy Stretch, an analyst with CIBC Capital Markets.

However, over the medium-term, CICB Capital Markets expect ongoing GBP gains as the prospect of a gradual re-opening of the economy in the second quarter of the year portends towards a consumer oriented boom.

"The recent rally in GBP crosses has been brutal. I remain USD (modestly) bearish but the run in sterling seems overdone and priced too much positive expectations (COVID). We shouldn't forget the structural headwinds due to Brexit," says Vasileios Gkionakis, Global Head of FX Strategy at Lombard Odier & Co Ltd.

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"We see bumps in the road ahead and see scope for pullbacks in the spring," says Jame Foley, Senior FX Strategist at Rabobank.

Foley cites some lingering fundamentals to keep alive expectations for the Sterling rally to ultimately find a limit:

1) The EU-UK Brexit deal was relatively limited, the services sector was "left out in the cold".
2) issues related to red tape at the UK’s borders
3) problems connected with the Northern Ireland protocol
4) Scottish elections in May could reignite expectations for another IndyRef

However Foley sees Sterling settling at higher levels against the Euro in 2021, with EUR/GBP likely to trade around 0.85.

"Bullish momentum in the pound has pushed EUR/GBP through our long held 0.87 medium-term target," says Foley, "the move may have further to run in the near-term."

0.85 in EUR/GBP translates into a Pound-to-Euro exchange rate of ~1.1765, 0.87 equates to ~1.15.

But some analysts who were once decidedly bearish on Sterling's prospects are shifting their views.

Analysts at Bank of America entered 2021 holding a pessimistic view on the currency, but they have noted a multi-faceted shift in sentiment towards the currency and UK assets in general.

Indeed, they recently flagged the largest jump in real money flows into the UK in a decade.

"We think that the market set-up remains conducive for further GBP upside particularly as we head into the most significant seasonal month for GBP in April," says Kamal Sharma, a foreign exchange strategist at Bank of America.

Bank of America modelling is supportive of further near-term upside in the British Pound, saying "if markets are no longer interested in Brexit then the call on GBP essentially becomes one on how durable the global risk rally can be and whether the move in bond yields does not spill-over into broader risk sentiment."

"The UK looks well placed to emerge from the latest lockdown against the backdrop of an impressive vaccine rollout," says Sharma.