Deutsche Bank Release Upgraded Forecasts for Pound vs Dollar and Euro, Shows Outlook Finely Balanced
Putting it all together, Deutsche Bank’s new Sterling forecast reflects a more optimistic view of the Brexit endgame, but not of Sterling fundamentals.
We reported on April 19 that Deutsche Bank had put its clients on notice that impending upgrades to their forecasts for Pound Sterling were coming.
Those upgrades have now been announced and show a more robust British currency going forward as analysts say they believe the risks of the UK crashing out of the European Union has been potentially averted.
But, the new forecasts are based on an assumption that Theresa May’s Conservatives gain a large majority on June 8 and therefore downside risks to the currency are to be found should the Conservatives fail to win a massive majority in parliament.
We would therefore imagine that if opinion polling suggests the same in the lead up to the polls Sterling would be vulnerable.
According to Deutsche Bank’s calculations, if the party fails to secure a majority in the region of 50-60 the Pound’s gains made following the election call are at risk.
The Pound enjoyed one of its best days in a decade, rising 2.7% to climb to a six-month high after Prime Minister Theresa May called an election for June 8.
Markets took the news as a sign that the government would be able to pursue a softer, more market-friendly version of Brexit on the basis of May enjoying a comfortable majority.
Markets assume May to be a moderate Conservative and breaking away from the grasp of the hard-line elements within her party will give her more flexibility.
Why May Needs a Big Win
Tuesday’s election announcement was described as a “game-changer for Brexit and Sterling,” by Deutsche Bank.
Last year analysts at the German bank argued an election was the only way to resolve the key political challenge the UK government faced with Brexit: the need to make major political compromises with the EU at the same time as being beholden to a small eurosceptic majority in parliament.
The prospect of a strong Conservative victory and therefore large government majority at the forthcoming election changes that outlook.
Prime Minister May would be in a stronger position to make necessary compromises with the EU.
But, “the Conservative Party must first secure a large enough majority to allow PM May to negotiate from a position of domestic strength and reduce the influence of fringe elements in parliament,” says Oliver Harvey, a Macro Strategist with Deutsche Bank.
Deutsche Bank calculate there are about 20 serial rebel Conservative MPs that have voted against the government on European issues.
But this represents only the ‘core’ of the eurosceptic vote. Sixty MPs backed a petition to leave the Single Market late last year.
In 2011, eighty-one voted against the government on a motion to hold an EU referendum.
“Allowing some leeway for the government to rally around eurosceptics behind its Brexit strategy, we would estimate that a minimum majority of between 50-60 seats is needed,” says Harvey.
A 10 poll average shows a Conservative lead of around 18 points.
Under a uniform swing, this would be enough to deliver a majority of between
110-150 seats suggest Deutsche Bank.
However, such a result may be an overestimate for two reasons warn’s Harvey:
First, the confidence in British pollsters to predict elections has been undermined in the last two years, with the 2015 UK general election a good example.
Second, this election is likely to be particularly unpredictable given that both the Conservatives and Liberal Democrats are seeking to pick-up votes in unfamiliar areas
The assumption that May will win big is already being questioned with a Survation poll for The Mail on Sunday putting the Conservatives on 40%, followed by Labour on 29 per cent and the Lib Dems and Ukip level on 11 per cent.
The findings suggest May’s lead over Labour’s Jeremy Corbyn has nearly halved in four days: a poll immediately after she called the Election gave the Tories a 21-point advantage.
We find these findings suggestive of the important role polls will play on the value and direction of movement in the British Pound over coming weeks.
“Our base case is nevertheless that the election delivers a majority large enough for the government to conduct talks without being undermined domestically. This reduces the need for market pressure under the crash scenario. But it won’t be enough to turn bullish Sterling in the medium-term,” says Harvey.
Others share this view.
“Looking ahead, while recent political developments on balance are positive, we are still moderately bearish on GBP over the medium-term. Even though tail risks have diminished, risks to growth still remain, especially relative to other countries which is more relevant for FX valuations,” says Meera Chandan at JP Morgan in a client brief dated April 24.
The Pound isn’t Actually that Cheap
There have been suggestions made that Sterling is due a recovery, because it is so cheap when contrasted to the strength of the economy.
This is however questioned by Deutsche Bank and would help explain why they don’t see the Pound rushing higher anytime soon.
Their analysis of Sterling levels on a Purchasing Power Parity analysis suggests the Pound is not that cheap, particularly against the Euro.
“On a PPP basis, EUR/GBP, which reflects the lion’s share of the trade weighted index, is now below fair value. GBP/USD is cheap as we estimate PPP fair value at 1.42. But this largely reflects the strength of the dollar,” says Harvey.
Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries.
Bank of England to Weigh
Also tempering enthusiasm for the Pound is the stance at the Bank of England whom Deutsche Bank believe will not shift their policy stance to the degree necessary to justify a fully-fledged Sterling recovery back to long-term fair-value.
The Pound continues to suffer from a dovish Bank of England and the market
is currently not penciling in a hike until the end of 2019.
“Based on two year rate differentials, GBP/USD therefore already looks very expensive and should drift down to around 1.15 next year if the forwards are realised,” says Harvey.
Against the Euro, the Pound could also be vulnerable to ECB tightening in the autumn.
“Sterling was the largest beneficiary of Eurozone outflows following the introduction of negative rates and QE in 2014 and 2015 respectively. If the Bank of England remains on hold, the Fed taper tantrum experience suggests some of these flows could reverse. Bank of England pricing does look extreme, but near term it is difficult to pin down what could make them turn more hawkish,” says Harvey.
The Economics Aren’t Supportive
Of course the decision-making at the Bank of England is actually a function of economic performance.
Inflation is their main concern and they will shift interest rates higher once their target of 2% is threatened in a sustained manner.
And should wages start picking up speed then the underlying inflationary picture would be deemed strong enough to warrant a Sterling-friendly interest rate rise.
The problem is wage growth remains static.
“On the inflation side, wage growth is frustrating again, with weekly earnings numbers having turned lower, and 6m6m core earnings point to further
downside. None of this suggests the BoE will be in a hurry to hike,” says Harvey.
Also concerning Deutsche Bank is the UK's persistent current account deficit. This is essentially the UK's bank balance with the world which shows the UK is running a medium-term deficit to the tune of 2-4.5%.
The deficit arises as the UK imports more than it exports, i.e it pays out more than comes in. However, the books are typically balanced by supportive investor inflows and earnings from UK investments overseas.
The problem is that relying on these inflows in times of uncertainty - for example Brexit - could see these inflows questioned which places significant downward pressure on the Pound.
Deutsche Bank would turn more bullish on Sterling were the deficit to decrease, and they don't see this happening in the foreseeable future.
Updated Pound Forecasts
Putting it all together, Deutsche Bank’s new Sterling forecast reflects a more optimistic view of the Brexit endgame, but not of Sterling fundamentals.
“We have revised the GBP/USD cycle end-point eight big figures higher from its previous low of 1.06. This returns it to levels after the Brexit vote, but before PM May’s ‘hard Brexit’ Birmingham Party Conference Speech, consistent with a reduction of crash risk,” says Harvey.
EUR/GBP is kept unchanged from present levels until 2019, reflecting our view of broadly balanced risks for the UK and the Euro Area over the next two years.
EUR/GBP at 0.83 equates to a Pound to Euro exchange rate at 1.2048 and 0.8 EUR/GBP equates to GBP/EUR at 1.25.