Sell the Pound say BAML Citing Growing Seasonal, Political Headwinds

• Quotes at time of publication:
• Pound to Euro Rate Today: 1.0940
• Pound to Dollar Rate Today: 1.2862

A new strategy recommendation on Pound Sterling has been issued by a noted foreign exchange analyst.

Kamal Sharma at Bank of America Merrill Lynch says seasonal factors and political risks are likely to combine to make the final months of 2017 particularly difficult for Sterling.

He recommends selling Sterling against the Dollar as a result. 

The call comes days after we reported a similar stance being adopted at Nomura who believe the Euro is to rise against the Pound in summer markets and recommend a long EUR/GBP trade as a result.

Sticking with the summer theme, this week we can report that Rabobank believe this will be a “soggy summer” for Sterling owing to lacklustre data - while the Pound might be able to stage a recovery rally against the Euro in the near-term, it is ultimately going to trade lower over coming months.

But where Rabobank are looking to data as a driver of Sterling value, Bank of America reckon data is no longer the driver of the Pound it once was.

Indeed, “the correlation between GBP and UK data surprises remains weak,” argues Sharma. “Politics, more than data, matter for GBP and with a heavy Brexit calendar through to year-end we take this opportunity to establish a GBP short.”

Sharma believes markets are unprepared for upcoming Brexit-related risks.

“We doubt investors have any appetite to take on long positioning ahead of key events,” says Sharma.

The only way forward is down then.

A trigger to weakness could be found on any “heightened Euro-sceptic noise around the Conservative Party conference.”

The conference starts on October 1 in Manchester so there will be time for markets to digest the next round of talks, scheduled for end-August.

Ahead of this, markets will also be looking at the details of the position papers the UK is to release over coming days and weeks - again volatility could be heightened around this event.

The first paper released on August 15 shows that the UK will seek to avoid a cliff-edge Brexit by looking to establish a special customs union with the European Union for an interim period.

There has been little reaction in Sterling to the news which suggests the actual negotiations are what will matter for markets.

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Seasonality to Weigh

The August to December period is never kind to Pound Sterling suggests historical precedent.

The below chart shows the average performance of GBP from August-December over the past
10 years:

Sterling has historically underperformed in the final months of the year on average with December particularly weak for Sterling.

It is also worth noting that volatility in the currency also broadly rises over the same period.

Combine this historical view on volatility with the packed political calendar the UK faces, and you can understand why Sterling might be in for a busy period.

Risks to the View

Anyone who has ever traded financial markets will know the risks involved in taking any position.

Betting against the Pound at this juncture is no exception - there are risks and BAML acknowledge this.

“With little progress made in the negotiations so far, there are risks on both sides of our central scenario of a hard Brexit with extended transition,” says Sharma.

BAML’s worst-case scenario for GBP remains talks breaking down completely “whilst domestic politics also present downside risks to Sterling.”

Theresa May and other Conservative Party big-hitters are fond of the mantra “no deal is better than a bad deal” whereby the UK will fall back on WTO trade rules rather than accept a punishing Brexit.

For BAML, “such a scenario which is probably the worst case for the currency as this would trigger a full blown current account crisis and a move towards $1.10 in GBP/USD as the UK potentially falls back onto WTO rules.”

We however question how a punishing Brexit could be better than WTO rules - surely the UK would only decline a Brexit deal if the outcome were worse than the deal on the table?

Nevertheless, “We think the political and seasonal headwinds are likely to intensify,” says Sharma.

Political risks include the prospect of a leadership challenge to PM May and even another general election.

This would be problematic as such an outcome would pose downside risks to GBP since the main contenders for the leadership are from the Eurosceptic wing of the party; some have voiced a more ideological approach to the negotiations.

Presently, Brexit Secretary David Davis is favoured to take over from May, followed by back-bencher Jacob Rees-Mogg.

“The Conservative party conference in September could be an important gauge on how the grassroots party reacts to the Prime Minister,” says Sharma.

But, risks are two-way, and Sterling could surprise the pessimists by staging a rally.

“On the flip side, a speedy agreement on the ‘divorce’ bill and EU citizens rights would facilitate new trade deal talks, which if successful, would be bullish for GBP and potentially pave the way for UK rate hikes,” says Sharma.

How to Trade the Weaker Pound

So with Sterling expected to weaken into year-end, BAML are looking to buy a six-month  put targeting at 1.25.

BAML’s house forecasts see the Pound to Dollar exchange rate ending the year at 1.24 ahead of a recovery to 1.32 in 2018.

The Pound to Euro exchange rate is forecast to end the current year at 1.1494, which is where consensus estimates place it.

The exchange rate is forecast to occupy this space for much of 2018.

Flows Data Confirm Investors Shedding Exposure

Potentially adding to BAML's view on Sterling is the bank's own insider view of currency market investor intentions.

All client types at the bank - corporate accounts, reserve managers, hedge funds and institutional accounts, like mutual funds, pensions and endowments - have sold the Pound over the past two weeks according to their flow data.

“The overall GBP market position is neutral, but real money is long, suggesting downside risks as they have been selling in the last three weeks,” says an analysis of the data.

If these clients continue to unwind exposure the Pound will certainly feel further strain.

Politics: Reaction to Position Papers Muted

The all-important Brexit front has seen some developments over recent days with the UK publishing the first in a set of position papers covering their position on Brexit. 

The first paper sets out an intended transitional period via the implementation of a bespoke customs union to come into force on the day the UK exits the European Union in March 2019.

Wednesday, August 16 sees the release of a second position paper - this time on the Irish border.

British and European negotiators need to show “flexibility and imagination” to devise post-Brexit arrangements on the island that preserve free movement of people and goods across the border, the Brexit Department said in an overnight statement.

“Top of our list is to agree upfront no physical border infrastructure — that would mean a return to the border posts of the past and is completely unacceptable to the U.K.,” the department said.