British Pound to Retreat Against Euro and Dollar Over Next 3 Months

• Reference rates (12-5-17):
• Pound to Euro exchange rate today: 1.1836, down 0.23% on the day's opening level
• Pound to Dollar exchange rate today: 1.2856, down 0.22% on the day's opening level

The British Pound is forecast to decline against the Euro over the course of the next three months by a noted European investment and financial services instution.

Warnings that Sterling is looking over-priced at current levels against the single currency come on the day Sterling dipped against a host of its major competitors on news the Bank of England had downgraded its forecasts for the UK economy for 2017.

Slowing growth rates in the UK are one reason why analysts at Intessa Sanpaolo say they expect further declines in the Pound’s value against the Euro and US Dollar.

But, for Intesa Sanpaolo it will be politics that weigh more than any other factor.

“The likely mounting of tensions with the EU over Brexit as soon as negotiations begin leaves Sterling exposed to a retreat,” says Luca Mezzomo, Chief Economist at Intesa Sanpaolo.

Only a strong set of economic data releases is seen negating their view.

And news that the Bank of England is cutting their growth forecasts for the UK economy to 1.8% for 2017 put paid to such expectations. 

Downside in the Pound Front-Loaded

Intessa Sanpaolo have this week written to clients to confirm expectations for a decline of the Pound in the near-term.

“This time horizon should bring the most unfavourable developments, both in terms of data, as inflation should keep rising and consumption should keep contracting, and in terms of Brexit, as negotiations will begin immediately after the elections on 8 June, and will be toughest in their initial phase,” says Mezzomo.

They forecast a downside margin for GBP/USD of up to 1.24-1.20 on a one- to three-month horizon.

The EUR/GBP exchange rate is meanwhile forecast to rise to 0.85 and 0.88 on the back of Sterling’s weakness.

From a Pound to Euro exchange rate perspective this equates into a decline to  1.1765 - 1.1364.

But, beyond the three-month timeframe the negative conditions weighing on Sterling are tipped to ease.

Negotiations beyond the initial ‘tough’ phase are more likely to be managed with the aim of reaching a compromise solution, that will allow an agreement to be signed before the two-year period provided for by the Treaty expires (in March 2019).

Intessa Sanpaolo believe efforts will be geared to avoiding exit without an agreement, which represents the worst-case scenario.

The resultant compromise and constructive tenor to negotiations should be positive for Sterling.

Why the June Election Call is Good for the Pound Longer-Term

Pound Sterling has been rising since mid-March with a particularly positive shift in velocity being provided by Prime Minister Theresa May who called for a June 8 General Election in early April.

Polling data suggests the ruling Conservative party should easily increase their majority thereby handing Prime Minister May a stronger hand both domestically and internationally.

Sterling instantly liked the idea of a more assertive Conservative government; one that would not leave Prime Minister May tied to fringe elements in her own parliamentary party nor pressure from opposition parties.

“The most plausible explanation for the Pound’s sharp upward reaction lies in the case made by May to justify the sudden decision to call a snap election,” says Mezzomo. “The idea that a stronger government at home – or with a stronger mandate following the June vote – may also prove stronger on the foreign front, and specifically in managing negotiations with the EU on Brexit, is rather weak.”

The agreement reached between the UK government and the EU on future trade relations will have to be approved by Parliament.

Intesa Sanpaolo believe that if the Conservatives effectively manage to increase their number of parliamentary seats, the agreement is more likely to be approved.

“Specifically, the risk of an exit with no agreement, which would undoubtedly be the most unfavourable for the UK economy, would decrease,” says Mezzomo.

This seems to explain the Pound’s upside reaction to May’s announcement as traders anticipate a more Sterling-friendly environment at the time of Brexit’s final execution.

Furthermore, “a stronger government should be able to guarantee greater political stability, by now means a negligible factor in a difficult and delicate phase such as the one that will immediately follow the United Kingdom’s exit from the EU, in March 2019. This is also a supportive factor for the exchange rate,” says Mezzomo.

Meanwhile, we can report that strategists at RBC Capital Markets have told clients they are bearish on Sterling over coming weeks as they believe the premium afforded to the currency from the calling of the General Election has been used up.

Analysts at the Canadian financial services provider note that markets are fully pricing in a UK Conservative majority of 130–150 seats on June 8 and therefore any premium GBP carries as a result is more likely to partially reverse

"There is good value in positioning for this pre-election risk given very low levels of short-dated implied vol and we are biased to be tactically short GBP," say RBC Capital Markets in a note to clients dated May 12.

Longer-Term Forecasts see Sterling Recovering

Beyond the near-term risks to Sterling set out above, Intesa Sanpaolo continue to expect a modest recovery of the Pound further out.

They see the currency rising and then levelling off at around its current levels, towards GBP/USD 1.28-1.30 on a one-year horizon.

But, against the Euro, upside gains are likely to be less forthcoming.

“The simultaneous forecast strengthening of the EUR/USD exchange rate on the same time horizon would limit the recovery of the Pound against the Euro, which would therefore also roughly stabilise at its present levels, of around EUR/GBP 0.85-0.86,” says Mezzomo.

This equates to a forecast on Pound to Euro at 1.1765-1.1628.

This will make for incredibly frustrating reading for those hoping for a stronger Pound against the Euro.

In essence analysts see the GBP/EUR sitting exactly where it is now in twelve months.

This view is mirrored in the latest forecasts set out by the UK’s Lloyds Bank who have told clients they see GBP/EUR floating near current levels for a protracted period of time.

So it is certainly not a niche expectation.

But - there is a caveat from Intesa Sanpaolo that allows for a stronger Sterling against that set out in their expectations.

“In light of the resilience displayed of late by the Pound, the balance of risks to the scenario has shifted, and is now skewed slightly upwards, i.e. Sterling may prove stronger than expected,” says Mezzomo.

Intesa Sanpaolo have allowed for the possibility that Sterling strengthens on the back of unexpectedly-strong UK economic data releases.

After all, the UK economy has outpaced the expectations held at the vast majority of institutional researchers since the June 2016 EU referendum.

While Sterling fell following the EU referendum the economy has maintained a steady growth rate.

There is thus the risk that this strength is maintained through Brexit negotiations and into Brexit itself which would once again catch forecasters with their pants down.

In such a scenario the excuses for a weaker Sterling run increasingly thin and the undervalued currency races higher to meet fair valuation dictated by the economy.

The bottom line? While no runaway strength is forecast by Intesa Sanpaolo they, like a great deal of their peers, believe the downside risks to the currency have been reduced significantly.