British Pound Finds Little Traction on May's DUP Deal, seen 3% Undervalued Against the Dollar & Euro

Ongoing weakness leaves Pound Sterling notably undervalued but we believe that upcoming events will provide some relief for the currency.

• Pound to Euro exchange rate (27-6-17): 1 GBP = 1.1374 EUR, +0.02%
• Pound to Dollar exchange rate: 1 GBP = 1.2731 USD, +0.09%

While we saw how important talk from Bank of England decision-makers was in the previous week, it is still politics that ultimately matter for the British Pound this week.

And we have a suspicion that, barring an absolute catastrophe for the Conservatives in Thursday's vote on the Queen's Speech, events should prove mildly positive from a currency angle.

Indeed, the first big event of the week is the signing of a deal between the DUP and Conservative government that will see the DUP support the Government on key votes and this allows Theresa May some much-needed certainty.

This should allow the provision of stable Government which will surely be welcomed by the British Pound which is tired of being undermined by the UK's apparently never-ending political saga.

The deal sees up to £1.5BN worth of financial support flowing to Northern Ireland while the DUP also claim to have secured guarantees that the triple-lock on pensions remains, as do winter fuel allowance payments in their current form.

Gains to be Short-Lived

“Theresa May has been on a very bumpy ride ever since announcing the snap general election back in April, but the deal with the DUP has steadied the ship, for the time being at least,” says Dennis de Jon, Managing Director at UFX.com.

de Jong says it comes as no surprise to him that the Pound has rallied against the Dollar and Euro following the news, with the markets breathing a sigh of relief that the Conservatives can now form a government.

The Government can now pass the majority of its programme through Parliament, however the positive impact on Sterling could be short-lived.

"The DUP and Conservative parties have come to an agreement to support for the government in UK parliament. Key references include the DUP providing support in all confidence/ budget motions and to vote in favor of the Queen’s speech, as well as support on national security bills and Brexit matters. This could see GBP entertain some bid risk on the week though we think it may be fleeting against the EUR and USD," says Mazen Issa at TD Securities.

Kathy Lien, Director at BK Asset Management says it is good news for the currency that May has kept her job, but bad that it has come at such a cost.

"Sterling traded slightly higher because this deal removes a key layer of uncertainty for the U.K. economy but the rally was unimpressive because the hung Parliament puts May in the difficult position of battling to pass other laws and striking deals on non-budget and Brexit issues on a case by case basis," says Lien.

Proof that Politics Matters for Sterling and the Currency is Undervalued

While the Bank of England matters for Sterling via the interest rate channel, studies do confirm that politics still hold the key for future travel.

“While GBP/USD does remain most sensitive to short-term interest rate differentials (see chart), our financial fair value model for GBP/USD points to a 3% risk premium priced in at present. We attribute this to current state of politics in the UK and questions over the stability of a minority Conservative government,” says Viraj Patel at ING Bank N.V. in London.

“Markets will also remain mindful of domestic political risks, which could
just as much drive the Sterling currency outlook, as interest rate differentials,” says Hann-Ju Ho, Senior Economist at Lloyds Bank.

Therefore, those hoping for a stronger Pound must watch headlines closely for signs of either improvement or deterioration in the fortunes for the Government.

Still on the agenda:

1. Ongoing Brexit negotiations
2. The debate on the Queen’s Speech, with a vote expected by next Thursday
3. The government is also expected to present details of proposals on rights for EU citizens after Brexit on Monday.

Concerning the outlook, we believe risks for Sterling are tilted to the upside.

Why? Because the currency has failed to break new multi-year lows against both the Euro and the Dollar.

Sterling is looking quite sticky to the downside and when the currency’s massive undervaluation is accounted for we get the sense that good news concerning the political outlook will have an outsized impact on the currency.

The obvious catalyst to an upside move would be the striking of a deal between the DUP and Conservative party.

This could ensure the Government manages to get through the next five years more or less intact, providing some certainty in uncertain times for the UK.

Bank of England Supportive, but no Game-Changer

The Bank of England has meanwhile started playing a more prominent role in Sterling's fortunes once more.

Suggestions made by the Bank's Chief Economist, Andy Haldane, that the time is right to implement a 0.25% interest rate rise saw Sterling move higher in the previous week.

Higher interest rates tend to support currency inflows from global investors seeking out higher returns on their capital.

Should the Bank point to a future of higher rates, these currency inflows could extend and thus shore up the value of the Pound.

However, ING’s Patel says while he prefers to ignore the “noise” coming out of the Bank of England he does acknowledge that hints of an interest rate rise in the future have helped cement a floor under the Pound.

“Bar any knee-jerk GBP moves that will arise from further mixed signals, we think at best the current neutral-hawkish BoE sentiment will put a floor under GBP/USD around 1.2550 and limit EUR/GBP upside to 0.8850,” says Patel.

EUR/GBP at 0.8850 equates to a floor in the Pound to Euro exchange rate at 1.1299.

However, ING are a little more negative than we are and believe ultimately Sterling is going lower.

Analysts don’t envisage an interest rate rise at the Bank of England in 2017 and “near-term risks to GBP lie to the downside”.

The bank is targeting a longer-term base in GBP/USD at 1.24 and GBP/EUR at 1.11.

Summer Doldrums = Poor Risk/Reward on Trading the Pound

Foreign exchange volatility has plummeted with the Pound trading tight ranges against the likes of the Dollar and Euro.

But it is not just the Pound that is sticking to recent ranges; the phenomenon is seen across the market.

“The summer solstice last week was marked appropriately by year-to-date lows in FX implied volatility,” says Kit Juckes at Societe Generale. “The summer doldrums have thus descended on the FX market. It is difficult to see what would stop the market being lulled into a deeper slumber in coming weeks.”

Juckes warns that the volatility decline cannot keep going on, “but it is a mug's game to speculate exactly when and why it will spike.”

In such conditions, traders are urged to stay out of the market.

“Cable is firmer but still essentially range-bound between 1.26/1.28; with spot essentially mid-range, there is little or no incentive for the market to get involved at this point as risk/reward considerations are sub-optimal. Look for ranges to hold for now,” says Shaun Osborne, Chief FX Strategist with Scotiabank in Toronto.