British Pound Forecast 2016: Brexit and Austerity to Keep Gains Capped

The EU referendum and a fresh round of fiscal austerity could keep a lid on the pound sterling's strength in 2016 but strong economic fundamentals should provide a floor to any declines.

As we enter the final throes of the year the outlook for the British pound in 2016 is bright with strong domestic growth and increasing employment and wages likely to continue providing support.

Strong data means interest rate rises at the Bank of England are therefore needed with markets pricing in the first rate hike towards the end of 2016 - a stark contrast to the likes of the European Central Bank who are possibly going to cut interest rates once more. 

"One European currency long expected to join the USD among those positively responding to global divergence themes is GBP," says Shahab Jalinoos at Credit Suisse, "given the UK's tight labor market and signs of wage pressures, our economists expect the BoE to follow the Fed relatively quickly in hiking rates."

Credit Suisse analysts see a first BoE hike in August 2016, which would benefit GBP.

"But if we look further out, the elephant in the room remains the possibility of a "Brexit" referendum, most likely in H2 2016," warns Jalinoos, touching on the one key risk to GBP strength in 2016.

More Brexit Reading:

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Forecasting British Pound Volatility in 2016

Political risk is a big issue for sterling which relies heavily on foreign inflows to prop up its value.

The UK is a net importer and to balance the trade budget inflows of foreign capital are important. Political uncertainty is the one switch that can kill these much-needed inflows.

"As the Scottish referendum and UK general election earlier this year showed, such events have the potential to create market volatility as they approach, not least in light of the UK economy's leveraged balance sheet," says Jalinoos.

What the above shows is GBP volatility started rising six months ahead of the Scottish referendum and the UK general election.

The potential economic ramifications are substantial.

Credit Suisse believe investment spending could suffer or foreign investors may avoid financing the UK's still-large current account deficit - the UK has large funding needs through "other investments," such as bank lending.

"This poses a risk of GBP sell-offs amid high volatility. With GBP implied volatility at subdued levels, arguably the risk return for short GBP/long volatility trades that perform in a risk-off environment linked to a "Brexit" referendum should be considered once the exact date is known and we reach the 6-month window," says Jalinoos.

Government Spending Cuts: Another Potential Weight on £

The UK's Conservative Party was voted into power on the promise that they would reduce Government spending which rocketed, as a percentage of GDP, between 2000 and 2010.

While the long-term benefits of balanced spending are to be desired, a short-term shave to economic growth is expected as fiscal flows to the economy are turned off.

"Along with Japan, current IMF projections show the UK as among the biggest losers in the G10 space in terms of 2016 GDP outcomes from fiscal retrenchment," says Jalinoos.

That said, with UK economic growth headed in its current direction there is probably no better time to shave expenditure. Indeed, in the context of any future global slowdowns those governments that have amassed spending fire-power during the good times will likely be better served.

We also note that the Bank of England places little emphasis on fiscal expenditure when making their interest rate calls and and as such the overall impact on sterling could be limited.