Pound Forecasts vs. Euro and Dollar Upgraded at JP Morgan but there’s a Catch

A restless Bank of England warrants tweaks to near-term Sterling forecasts but the world’s largest investment bank believe uncertainty about the future path of interest rates will keep the Pound under pressure through 2018.

Currency analysts at JP Morgan have upgraded their short- and medium-term forecasts for Pound Sterling but the American banking giant is sceptical of the Bank of England’s intent and its ability to sustain a tighter monetary policy over any meaningful period of time, suggesting broader risks around the Pound are still to the downside.

The view leaves some fine-tuning to projections for Sterling as a result.

The upward revision to some Sterling projections come after the BoE said in September that a majority of rate setters expect to vote for a withdrawal of stimulus over the coming months if the economy remains on an even keel and inflation heads further north of its 2% target.

The Pound rallied in the wake of the announcement and brought about a readjustment in expectations for the Pound amongst analysts. We have reported a number of upgrades for Sterling of late as a result, for example this week saw analysts at Lloyds Bank nudge higher their projections.

But the BoE picture is a mixed one say JP Morgan who are inclined to keep any upgrades minimal.

“There is a lack of clarity about what has prompted the shift in the BoE’s reaction function as the MPC has offered partial and sometimes conflicting explanations for its abrupt change of heart,” says Paul Meggyesi, vice president of global currency and commodity strategy at JPMorgan.

Meggyesi notes the contradiction between the BoE’s recently expressed confidence about an acceleration in actual growth versus its continued pessimism about “low potential growth”.

He also flags a reversal in the bank’s previous position on whether it is more important to fight an “inflationary supply shock” or to prop up demand by keeping rates low.

“Uncertainty about both of these issues imparts a greater than usual degree of instability in the expected future path for monetary policy, and so too by extension the outlook for GBP,” Meggyesi says.

The UK yield curve, which is a reflection of bond market pricing as well as future interest rate expectations, is implying a “normal hiking cycle of around 100 basis points” over the coming years.

There are currently another two full 25 basis point rate hikes pencilled into the proverbial trader’s diary for 2018 alone.

“But there is little about the UK business cycle that can be considered normal, either in terms of the atypically weak momentum in the economy at the onset of a hiking cycle, or the prospective and as yet unknowable GDP shock from Brexit,” says Meggyesi.

Indeed, the Pound fell on Tuesday, October 18 when Bank of England Governor Mark Carney appeared before UK lawmakers and failed to indicate the Bank is keen to pursue further interest rate rises in 2018.

The UK government’s move to seek a transitional arrangement, or so called implementation period, before anything has even been agreed has softened market concerns of an imminent calamity but Meggyesi says the end destination still implies a considerable amount of disruption for the economy over the longer term.

“Our best judgment is that a more hawkishly-minded BoE does warrant an adjustment in the level of GBP but it doesn’t necessarily justify a material upgrade to the medium-term path for the exchange rate,” says Meggyesi.

But risks are to the downside, not just in regards to the long term performance of the economy, but to Sterling in the very short term as well.

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Calibrating Brexit-Related Risks

While the Bank of England offers some near-term potential upside in Sterling, the broader picture remains unconstructive and is why JP Morgan are not extending forecast upgrades to their longer-term projections.

An absence of progress in the so-called divorce talks between the UK and the EU heightens the risk of the UK government quitting talks and opting to leave the EU without any agreement on future trade.

“In all, we judge that the immediate political risks are skewed towards a widening rather than a compression in the Brexit risk premium,” says Meggyesi.

The strategist observes that the risk premium attached to Sterling in recent times has led the currency to trade at around an 11% discount to estimates of its fundamental.

However, he warns this discount could soon dissipate in the event of a Brexit calamity where interest rates are cut by 75 basis points into negative territory, prompting the “fundamental value” of the Pound to fall sharply.  

“That doesn’t seem to be a particularly egregious assumption to us, and we are not minded to earn the risk premium from owning GBP.”

Forecast Changes

JPMorgan has cut its fourth-quarter forecast for EUR/GBP, from 0.93 to 0.90, which implies a Pound-to-Euro rate upgrade to 1.1100 by year-end.

This is an improvement on the bank’s earlier 1.0750 forecast although it still implies some downside from the current market price of 1.1216.

Maggyesi has also raised his fourth quarter Pound-to-Dollar forecast from 1.3000 to 1.3300.

For the 2018 year, JPMorgan’s EUR/GBP forecast has fallen from 0.935 to 0.9200, which implies a Pound-to-Euro rate of 1.0869.

The bank’s Pound-to-Dollar forecast has risen from 1.3400 to 1.3600 for 2018.

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