HSBC: Pound Sterling Downside Risks v Euro Grow but More Sanguine v US Dollar in Short-Term

The under-pressure British Pound found relief during the past week in response to the Bank of England’s June policy decision that showed an increase in the number of policy-makers willing to raise interest rates.

The move caught markets by surprise and gilt yields rallied as they brought forward expectations for an interest rate rise.

This rally in gilt yields helped push GBP higher, yet the Pound only managed to end the week 0.2% higher against the Euro and 0.3% higher against the US Dollar. Against the Australian and Canadian Dollars it was o.89% and 1.6% lower respectively.

Indeed, despite the positive development at the Bank of England, analysts at HSBC are not convinced that chasing Sterling higher is the right strategy to pursue at this stage.

In fact, “our medium-term bearishness on GBP has been bolstered by the increased political uncertainty generated by the recent general election result,” say HSBC in a client briefing dated June 16.

However, it's not just a uniform picture as expectations on Pound Sterling differ according to which currency it comes against.

With regards to GBP/USD the outlook is a little more benign we are told.

“Tactically our pessimism is a little more tempered, principally because there appears to be a sizeable constituency in the market content to buy GBP on a dip to around 1.27.”

According to analysts, the fundamental support for GBP/USD below 1.27, despite the uncertainty created by the election result relies on an assumption that it increases the chance of a soft Brexit.

"This has some merit," say HSBC. "The DUP may favour a soft rather than hard Brexit to minimise the risks to the Northern Ireland peace process. Conservative Party MPs in Scotland are also likely in favour of
soft Brexit."

"Suggestions of cross-party involvement in crafting the UK’s negotiating position might also pull the UK away from a hard Brexit outcome. Changes in personnel within the UK’s Brexit department have helped reinforce expectations of a softer stance," adds the note.

The pull-back in GBP/USD since the 8 June election has been smaller than HSBC would have expected for a minority government outcome.

They do however see support at this level ultimately failing and 1.25 forming the bottom of a longer-term range. So nothing cataclysmic here.

However, strategists think the balance of risks are still to the downside and they prefer to be selling GBP, especially against the EUR and JPY.

HSBC have previously warned they see the Pound to Euro exchange rate potentially falling to parity by the end of 2017.

"We believe the pressures are building on the politics and economics to question the resolve of those currently buying GBP on the dips," say HSBC. "The problem is the mood could change."

Analysts reckon the election may also have increased the chance of a ‘no deal’ outcome.

This view is shared by George Saravelos at Deutsche Bank who says a disorderly Brexit is a major threat to Sterling valuation at present.

Analysts agree that time is of an essence now that the clock for agreeing a deal under Article 50 has been ticking for three months, and the negotiations have yet to begin.

The new UK minority government could prove fragile and the threat of a fresh election will loom.

"In addition, when negotiations do get underway, the opening salvos may be acrimonious as the sides lay out their starting points with a view to compromising over time. For example, the EU wants to talk about the Brexit bill. The UK seems less inclined," say HSBC.

A new election would almost certainly result in a majority Labour Government according ot the latest polling by YouGov which has confirmed Theresa May's popularity has plunged.