Pound Sterling Straddles 2023 Highs against Euro and Dollar But is Ripe for Disappointment Says BNP Paribas in Latest Forecast Update

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The British Pound's stellar 2023 will ultimately unravel at some point in the coming weeks as the UK economy begins to underperform rivals say BNP Paribas in a new currency forecast note.

A high-flying Pound is particularly vulnerable to losses against the Euro says the French investment bank, which has been a long-time 'bear' on the UK currency.

The bank's bearish stance on Pound Sterling has thus far been frustrated by the UK currency's outperformance in 2023, which has taken the Pound to Euro exchange rate to a ten-month high just last week at 1.1707.

A 14-month high in the Pound to Dollar exchange rate was meanwhile achieved on June 14 at 1.2698.

"The GBP has continued to trade well over the past month, despite sticky shorts having already been washed out," says Parisha Saimbi, G10 FX Strategist at BNP Paribas in London.

"This could be explained by the resilient data (in particular the recent inflation print for April), which has prompted markets to price in higher expectations for further tightening," she adds.

Sterling gains most recently followed the June ONS labour market report that showed an unexpected dip in the unemployment rate and a stronger-than-expected increase in job creation and wages, confirming persistent labour market 'tightness'.

Economists say the rise in wages means UK inflation will remain stubbornly high for the foreseeable future, prompting countermeasures by the Bank of England in the form of further interest rate hikes.

"While we agree that the data warrant some further tightening by the central bank, we see scope for the Bank of England to under-deliver relative to market expectations, or, if it keeps hiking, we think markets could increasingly interpret the UK as having an inflation problem," says Saimbi

"Both of these developments would be GBP-negative," she adds.

The market now anticipates about 130 basis points of further hikes from the Bank of England before the year is out, this contrasts with just 60bp from the European Central Bank and 25bp from the Federal Reserve.

This has allowed Pound Sterling to appreciate against the Euro and Dollar but it also leaves the currency ripe for disappointment: should these expectations retreat, so too could the Pound.

The potential for such a deflation could come next week Wednesday when inflation data is released; should inflation undershoot expectations the market would most likely reverse its current elevated expectations.

BNP Paribas' economists have revised their terminal Bank Rate forecast up to 5.5% (from 5% and 4.75% previously), as the sustained strength of inflation and potential concerns around second-round effects are likely to persist, prompting another hike in August.

If economists at BNP Paribas are correct and Bank Rate rises to 5% there is scope for a substantive rerating lower from the market's current expectation for Bank Rate to peak at 5.75-6.0%.

Above: "Pandemic savings have been spent and eroded by inflation" - BNP Paribas. Sources: Bank of England, Macrobond, BNP Paribas.

The Pound has powered ahead on the back of a series of UK economic prints that have beaten expectations, should data disappoint from here the trend could be reversed.

As the above chart shows, the UK's businesses and consumers are whittling down their pandemic-era savings build-up, potentially signalling a slowdown in consumption-lead economic activity.

"With real incomes still being squeezed households are relying on their savings, and while these have eroded significantly, they are still some above pre-pandemic levels. We expect growth to slow in H2 2023 and H1 2024 as current momentum weakens, the global economy slows and interest rates start to bite. Fiscal policy and quantitative tightening will act as a drag on growth," says Saimbi.

BNP Paribas currency analysts say they expect Pound Sterling "to remain structurally weak due to UK growth underperforming its peers, remaining below-trend, and its persistent current-account deficit that requires foreign funding."

The call comes despite the UK's ongoing economic expansion and confirmation last week that the Eurozone had fallen into recession, suggesting outperformance.

Nevertheless, BNP Paribas forecasts EURGBP to right itself and recover its recent losses, rising to "0.88 in the coming months and trade around this level through to the end of 2024".

This forecast represents a downgrade, however, from a previous forecast of 0.89.

This translates into a Pound to Euro exchange rate forecast of approximately 1.1240.

BNP Paribas is meanwhile "structurally" negative on the Dollar, projecting the Pound to Dollar exchange rate to rise to 1.27 by the end of 2023 (down from 1.28).

Next Wednesday's UK inflation data is a key risk in the Pound's near-term calendar as an undershoot in the reported numbers could see recent Bank of England rate hike expectations reverse.

This would leave analysts at BNP Paribas feeling more comfortable with their GBP forecast profile.