Lloyds Upgrade Pound Sterling Forecasts vs. Euro, Dollar but Downgrade for 2018

Lloyds Bank upgrade end-2017 forecasts for the British Pound  but have cut estimates for 2018 and beyond, while also remaining cautious in their projections for UK interest rates.

Lloyds Bank’s October publication of their International Financial Outlook sees analysts adapt their forecasts for Sterling by taking into account September’s warning on future interest rate rises at the Bank of England.

The call comes ahead of a busy week for Sterling on the domestic front with an appearance by Governor of the Bank of England Mark Carney and key inflation data due. Market consensus now expects interest rates to rise in November by 0.25%, while the more important question of subsequent interest rate rises open for debate.

“We forecast the BoE MPC to hike Bank rate by 0.25% to 0.5% at their next meeting on November 2. A further 25bp hike is pencilled in for Q3 next year, but there is a high degree of uncertainty given the UK’s political and economic challenges,” says Jeavon Lolay, head of economics and strategy at Lloyds Bank's Commercial Banking division.

The promise of higher interest rates attract inflows of foreign capital as investors seek yield. This in turns boosts demand for Sterling which is why the currency tends to rise when the Bank of England enters cycles of interest rate rises.

The call comes at a time when analysts expect the key driver of Sterling to shift away from politics and back to the economy and Bank of England monetary policy; this is a supportive development for the currency owing to growing expectations for future interest rate rises at the Bank.

“Deadlock talks, contingency planning around a 'no deal' scenario and talk of a transition deal shouldn't be new news and we think short-term - as well as broader - political risks are fairly priced into GBP for now. Therefore we expect to see little fallout in GBP when EU leaders this week conclude that there has been little progress in talks thus far,” says analyst Viraj Patel with ING Bank N.V. who says the economy and the Bank of England are likely to become increasingly important for the evolution of Sterling in the near future.

Lolay notes policymakers are looking to raise rates amidst concerns potential capacity constraints in the economy - i.e. the availability of workers - are going to push up wages and therefore inflation.

With regards to inflation's trajectory, Lloyds forecast a further increase in the coming months, with a breach of 3.0% in the headline rate requiring the BoE Governor to write to the Chancellor to explain why this has happened and what actions, if any, the Bank is taking to return inflation back to target over the medium term.

Headline consumer price inflation rose further than was expected during August, with the CPI index printing a reading of 2.9%, which is dangerously close to the three per cent threshold where the BoE will be expected to act.

Traders will be eyeing the Tuesday, October 17 release of CPI data and expect the figure to hit 3.0%, thereby cementing the view the Bank of England is likely to raise rates in November and once again in 2018. Anything stronger will have markets price in a further rate rise in 2018 which should boost the Pound.

By raising interest rates the supply of easy money into the economy is constrained, thereby impacting on demand and slowing price rises. While inflation is capped by rate rises there is also the risk that taking an aggressive approach to raising rates slows economic growth.

“Ongoing signs of weak productivity, subdued business investment and signs of diminished slack in the labour market suggest that any increases in economic capacity is likely to lag behind demand,” says Lolay. “As a result, we expect the MPC to sanction a further quarter-point rise in the second half of next year.”

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Economic Concerns Linger

Lolay also flags that the shift in tone in favour of higher interest rates at the BoE has occurred against a backdrop of a slowing economy.

Recent months have seen construction activity slow that the industry now teeters on the edge of recessionary conditions while a sharp cooling of PMI readings for other key industries has also been observed.

Car sales are falling while some parts of the housing market have also shown signs of softening.

“Economic uncertainties ahead, however, should limit the pace of tightening next year,” Lolay adds. “Brexit-related uncertainties are also expected to cap Sterling gains, keeping it below our ‘fair value’ estimates.”

Expectations for a November interest rate rises buy lingering uncertainty explain why Lloyds have adopted a more positive near-term view on Sterling and are cautious on longer-term timelines.

Forecasts for the Pound

The Pound-to-Euro exchange rate is now forecast to trade at 1.1200 toward the turn of the year, which is higher than the 1.0900 forecast in September.

However, the Pound will likely fall to 1.0700 by the end of 2018 as growth between the UK and Europe diverges. This represents a downgrade to Lloyds’ 2018 Pound-to-Euro forecast, which had envisaged the pair trading around 1.0900 at the end of 2018.

October’s currency forecasts suggest the Pound will trade around 1.3100 against the Dollar by the end of the 2017 year. This implies downside from current levels but represents an upgrade from Lloyds’ September forecast of 1.2800.

For 2018, Lolay and the team at Lloyds now project the Pound-to-Dollar rate will stay around 1.2800, which represents a downgrade from their earlier forecast of 1.33.

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