Further Pound Sterling Losses Against Dollar, Euro 'Inevitable' Warn UniCredit

Analysts are warning we should expect further declines in the British Pound amidst ongoing political uncertainty in the UK.

Analysts at UniCredit Bank have put clients on notice that they should expect their forecasts for Pound Sterling to be downgraded following the Conservative Party's razor-thin win in the General Election.

"Short-term there is little doubt that volatility will rise further and the spot will be susceptible to large intra-day swings, in part due to a plethora of political headlines hitting the wires. But looking beyond near-term fluctuations, it seems clear to us that sterling is subject to more pain," says Daniel Vernazza at UniCredit Bank in London.

The call comes as Prime Minister Theresa May confirms she will press ahead and seek to govern with the assistance of Northern Ireland's DUP.

But, Vernazza notes that political uncertainty should linger and is unequivocally damaging for the Pound exchange rate and the economy; "the deterioration in sentiment increases the risk of inflicting more pain to an economy that has just started suffering from a notable squeeze in real incomes on the back of anemic wage growth and rising inflation."

UK inflation was seen stabilising following the recent fall in Sterling, but it might well pick up again should another bout of weakness in the currency now ensue.

The next government should be aware that it might be inheriting something of a poisoned chalice.

Importantly, uncertainty over UK leadership will compound concerns over the UK's ability to negotiate a good Brexit deal leading, in UniCredit's view, to an acceleration of portfolio outflows putting even more pressure on the Pound.

Pound to go Lower as Investments Dry Up

The UK is reliant on the inflow of foreign investor capital to keep the value of Sterling elevated and its economy oiled.

When these inflows dry up Sterling must fall in order to create a discount for further inflows.

UniCredit point out that during the years of the Eurozone debt crisis (2010 to 2012) the UK experienced a surge of portfolio inflows as growth was firming and the economy was perceived to be a safe haven amongst G10 countries.

"But this has changed since the Brexit vote: indeed, balance of payments data for 4Q16 show that foreign portfolio investment is going into reverse. This process should gain more traction now that domestic political risk premia rise even further," says Vernazza.

As a result, UniCredit say their already bearish GBP forecasts (GBP-USD at 1.28 and EUR-GBP at 0.89 by year-end) "are now subject to deeper Sterling downside risk".

Note that EUR/GBP at 0.89 equates into a Pound to Euro exchange rate at 1.1236.

UniCredit see a fairly good chance that EUR-GBP rises to 0.90 rather swiftly and potentially towards 0.95.

In Pound to Euro exchange rate terms this equates to 1.11 and 1.0526.

Pre-election rate spreads suggested that Pound Sterling was actually looking expensive against the Euro.

"With the prospects now that over the next few weeks UK yields come under increasing pressure and Gilt-Bund spreads narrow even further, more upside for EUR-GBP seems inevitable in our view," says Vernazza.

"And to the extent that over the medium term U.K. yields rise as a reflection of elevated risk premia, any potential re-widening in the spread is unlikely to offer support to Sterling. Both short-term and medium-term GBP's prospects appear daunting to us."