British Pound's "Moment in the Sun is Coming to a Close"

• Latest Rates to Reference:
• Pound to Euro exchange rate: 1.1797, up 0.3% on the day
• Pound to Dollar exchnage rate: 1.2933, up 0.10% on the day

Ahead of the weekend Pound Sterling retains a positive bias against its two main rivals with a mixture of technical buying, stability on the political front and improving economic data providing support.

Indeed, it’s been a good few months for the British Pound which has been one of the best-performing currencies in the world since it bounced off multi-month lows back in mid-March.

But all good things must come to an end.

This is the house-view held by foreign exchange analysts at the London branch of Canada’s giant financial services institution TD Securities.

The Foreign exchange team have taken the view that the Pound’s recent run leaves the currency “looking increasingly stretched” relative to underlying fundamentals.

Analyst James Rossiter believes the UK economy is headed towards a slowdown of the magnitude that warrants a weaker Pound.

“The rapid deterioration in the UK’s economic momentum has largely gone unnoticed by an FX market preoccupied with political distractions,” says Rossiter in a research note dated May 3.

The call comes after a run of weaker official data with the preliminary release of GDP data for the first quarter showing the UK economy grew 0.3%, down from 0.7% in the final quarter of 2016.

A Strong Performance that Must End

TD Securities argue the “strong economy” narrative has been a key component supporting GBP in recent weeks.

This narrative comes amidst the “various twists and turns of the UK’s political landscape,” and “still the currency has been on a path of undeterred strength”.

Since the end of March, Sterling is the best-performing currency among a basket of 31 major emerging-market and G10 counterparts tracked by Bloomberg.

The GBP trade-weighted index is up by nearly 2.5% over this period and by almost 8% since its post ‘flash crash’ lows registered last October.

But Rossiter argues the “strong economy” narrative assumed by markets is about to be questioned.

Ironically, as we are penning this piece the final of the trio of PMI surveys for April suggest the UK economy is experiencing a revival in growth into the middle of the year.

Construction, manufacturing and service PMI data all beat expectations with Capital Economics estimating that UK growth will read around 0.6% in the second quarter on current trends.

This suggests the economic slowdown envisaged by TD Securities is not necessarily guaranteed.

But Rossiter sees no contradictions between his expectations for weaker growth amidst strong PMIs data releases.

“Our measure of UK data surprises has collapsed since the end of March. This is particularly pronounced among ‘hard data’ indicators. Survey-based indicators continue to run with a firm tone, as the large upside surprise seen in the April manufacturing PMI reading confirms, but clear cyclical headwinds appear to be emerging,” says Rossiter.

This view stands in stark contrast to those who would argue that were fundamentals to be put in the driving seat then the Pound would be much higher.

We reported recently that ING have upgraded their forecasts for the British Pound on the improved outlook.

Of note, ING say that the Pound is incredibly undervalued on a long-term basis and Brexit is unlikely to deliver the kind of economic slump required to justify such expectations.

Indeed, ING reckon we would need to see the kind of implosion in productivity witnessed during the great financial crisis of 2008 to justify levels in Sterling we have already witnessed in 2017.

A Weaker Pound

Nevertheless, “we think Sterling’s moment in the sun is coming to a close. We think the GBP’s relative and absolute strength is looking increasingly stretched relative to its underlying fundamentals,” says Rossiter.

The analyst argues that when the UK economy was on an upswing, investors could give Sterling the benefit of the doubt with respect to lingering Brexit risks.

Better macro data bought the currency a large amount of breathing room. But “this narrative now looks increasingly vulnerable,” says Rossiter.

And there is another dimension to consider - the external political environment may also be turning less friendly for Sterling argue TD Securities.

EU's Politicians to Deliver a Beating the UK Won’t Forget

The Pound has been helped higher by recent developments in the UK where investors have noted Theresa May’s decision to call a snap election on June 8 as being supportive of Sterling.

The idea is that should the election result in a solid Conservative majority the UK government will be allowed to approach Brexit negotiations with a united front, while deferring the next election to 2022, increasing the likelihood of a transition arrangement.

“While all of that may certainly be the case, it is at best half the story, in our view. From here, we think the market’s focus may start to shift away from the UK’s negotiating stance to that of the EU,” says Rossiter.

And he is certainly right on this front - the temperature between Brussels and London has certainly been rising.

“The Brussels establishment utilised tweets, leaks and a campaign of disinformation” Great piece @yanisvaroufakis https://t.co/x5tmpvpxAF

— The Pound Live (@thepoundlive) May 4, 2017

“There, the early indications point to a difficult road ahead,” says Rossiter.  

Recent headlines concerning the stance of the Brussels administration show that punishment is likely to be an intended outcome of impending negotiations.

In light of this we find the following line from TD Securities to be interesting:

“We agree with the view that the EU must impose clear costs on the UK for leaving - not (necessarily) to punish that country but rather to dissuade other members from doing the same.”

It appears that Rossiter and his team might be ideologically aligned to the view that Sterling and the UK economy should suffer for Brexit based on ideological views.

This kind of ideology is let slip by other institutional analysts who hold noted negative views on Sterling and the UK economy, for instance, this is UniCredit’s Head of Global FX Strategy:

Not a single month will go by without revealing that Brexit was a completely uncalled for disaster for Britain https://t.co/A7Zryy17dZ

— Vasileios Gkionakis (@VasileiosGkion1) April 25, 2017

The entire institutional community were hands-down of the opinion that the UK economy would suffer significant declines in economic growth in the immediate aftermath and beyond following the Leave result in June 2016.

These expectations have not yet transpired, yet the negative stance appears to persist and feed into forecasts for future performance of both the economy and the Pound.

Pound Forecasts Against the Euro

Let’s look at the numbers.

TD Securities are selective in where they think Sterling weakness may begin to be seen, i.e the Pound will perform better against some currencies than others.

From a risk/reward perspective, they currently think the GBP may have a relatively more difficult time against the EUR than the USD in the weeks ahead.

With the final round of the French election imminent, Europe’s political risk cycle is nearly complete and this should help the Euro outperform going forward.

“This leaves investors free to focus on the Eurozone’s steadily improving economy. In contrast to the UK, data surprises in Europe are on an upswing,” says Rossiter.

This, together with a pickup in headline inflation pressures has fuelled expectations in some quarters that the European Central Bank may recalibrate its policy language as early as June.

“With EUR/GBP near the bottom of the trading range seen over the last several months, this combination of factors may support a move to the upside from here,” says Rossiter.

TD Securities think a re-test of the 26 April high at 0.8531 is feasible for EUR/GBP and they see scope for a rally toward 0.8675 on longer-term timeframes.

This translates into a fall in GBP/EUR to 1.1721, ahead of 1.1527.

Note that these are strategic objectives and do differ from the official forecasts held by TD’s economists, although not by much.

Official forecasts held by the institution show EUR/GBP is forecast at 0.86 by mid-2017, 0.88 by end-2017 ahead of 0.87 by mid-2018.

This translated into GBP/EUR at 1.1628, 1.1364 and 1.1495.

Pound Forecasts Against the Dollar see Better Sterling Performance

TD Securities are however more constructive on the US Dollar, as reflected in our recent report on their view contained in May's monthly forecast assessment.

While interest rate differentials to the US point to significantly lower levels, analysts are not convinced these present a reliable barometer for short-term valuation of the USD pairs.

It is observed that the USD is trading at a considerable deviation from what rate spreads would imply against most G10 currencies.

“This, we think, points to a 'Trump discount' on the Dollar as well as a shift in global growth dynamics. As the global macro backdrop rotates from an emphasis on divergence to one on convergence, the factors supporting USD strength have waned,” says Rossiter.

That said, TD Securities think this week’s high at 1.2966 could offer decent resistance against which USD bulls cold sell, but they recommend tight discipline on stops reflecting less conviction on the call.

Downside targets can be found at 1.2757 and the 1.2595 “melt-up” level from 18 April.

Official forecasts held at the bank for GBP/USD see the rate at 1.24 in mid-2017, 1.27 by end-2017 and 1.33 by mid-2018.