Brexit Risks to Push British GBP/USD Rate Below 1.40 say Merrill Lynch

Analysts continue to stress the referendum on E.U membership as the single most important event for pound sterling exchange rates in 2016.

The British pound will weaken in the short-term as Brexit risks weigh, the Bank of England delays rate hike expectations and the U.K current account is exposed to the negative global outlook, say Bank of America Merrill Lynch Global Research.

In a note to clients covering the outlook for sterling researchers say the currency will however mount a recovery in as soon as the referendum passes as analysts believe voters will probably vote for the status quo and the U.K will remain in the European Union.

Post-referendum sterling will experience a resurgence as the major black cloud hanging over it evaporates, in addition its true fundamentals will shine through, which are that it is currently undervalued and that such low rates coupled with low unemployment make an argument for potential inflationary pressures, and a bank rate rise:

“Sterling is not significantly overvalued whilst Taylor rule measures suggest that the level of UK interest rates remains overly accommodative against a backdrop of an economy approaching full employment.

“Removal of Brexit risks will see a recalibration of UK rate hike expectations and a higher GBP.”

From a technical point of view, BofA sees a major risk of a break below 1.40 to the dollar and a potential move up to 0.80 to the euro.

Referendum 'Watershed' for Pound

The focus on Brexit as a major factor in sterling’s short-term outlook echoes a similar viewpoint held by ING Economics, who also see the referendum as a pivotal moment for the currency.

According to Viraj Patel, an analyst at ING, the key to sterling’s outlook rests with the European Council Meeting on February 18 and 19 when David Cameron will attempt to hammer out a compromise agreement with the rest of his European partners, so he can go back to the electorate in England with a ‘new deal’ for Britain, which he would then expect to result in a win for the ‘in’ vote: 

“The initial suggestion was that the referendum would be held by the end of 2017, but it could come as soon as this summer if a deal is agreed on at the European Council meeting on 18 and 19 February.

“The assumption is that Mr Cameron can then tell the electorate that he has won a “better deal for Britain” that will convince a majority of Britons to vote in favour of keeping the UK in the EU at a June referendum.”

Patel argues that the 18-19 Feb meeting will dictate when the referendum is, since if Cameron fails to secure a deal for the U.K then, he would probably put off having a referendum until possibly as late as 2017, in order to give himself more time do further negotiate with the E.U. 

Alternatively, a successful outcome from the February meeting would give him the courage to hold a June referendum and get the matter resolved.

The ING analyst argues that sterling is compromised until the referendum, both due to a slow-down in “Trade and Investment” as companies await the outcome, but also as a result of the BOE delaying normalisation.

“Irrespective of the outcome, the uncertainty that the vote will generate is likely to see a loss of momentum in the UK economy – possibly knocking around a quarter of a percent off 2016 growth.

“Both UK and foreign businesses are likely to take a “wait and see” approach to hiring and investment, while consumer spending and confidence could weaken modestly.

“The Bank of England will sit on its hands and sterling is likely to continue softening in the build-up to the vote – touching 1.32 versus the USD.”

Nor do ING see risks of a Brexit as overdone like BofA, as the following observation at the start of their note proves:

“UK Prime Minister David Cameron has a knack for winning the votes that matter. However, his luck may run out with the upcoming referendum on EU membership.”

GDP Data Strong

Sterling rose strongly after the release of positive GDP data on Thursday, promting questions as to whether this could prove a turning point for the currency. 

The figures showed a positive rise in growth of 0.5% in Q4, which was an acceleration from the 0.4% registered in Q3, nevertheless it was in line with expectations.

On an annualized basis, GDP rose by 1.9% compared to 2.1% in 2014, also as analysts had forecast.

Nevertheless, UniCredit's Daniel Vernazza, still sees downside risks to the economy in the short-term, echoing both BofA’s negative short-term view and ING’s even more bearish referendum watershed theory: 

“In the near term, UK economic growth is likely to remain close to but below its trend amid the fiscal squeeze, subdued global growth, heightened stock market volatility and the impending referendum on EU membership (which now looks likely to take place in June or July).

“That will likely keep the Bank of England on hold until the end of this year as one of Mark Carney’s three pre-conditions for a rise in interest rates – the renewal of above-trend growth – is unlikely to be met.”