Pound Forecast Back Above 1.40 vs. US Dollar in 2019 as Brexit Risk Premium Seen Falling: UniCredit

An agreement on a Brexit transitional period will reduce risk premium in Sterling and make it more likely GBP/USD will gain traction above 1.30-1.33 range.

The Pound-to-Dollar exchange rate could recover much of its post-referendum loss by the time the U.K. actually departs the E.U. in 2019 argue strategists, although politics will remain the dominant driver of Sterling over the coming quarters and so the road ahead could be a volatile one.

Assuming a transition deal is agreed over the coming months, setting the UK on course for an orderly departure from the E.U., the risk premium carried by Sterling since the Brexit vote in June 2016 could fade further still.

“Given our strong belief that the U.K. needs the E.U. far more than the E.U. needs the U.K., the UK government will likely cave-in to the EU’s proposal for the amount of the settlement bill in order to move on with trade talks,” says Dr. Vasileios Gkionakis, head of FX strategy research at UniCredit Bank. “This may be perceived as supportive of Sterling – mostly against the USD.”

The call comes on the day it is reported the U.K. cabinet is ready to sign-off on an increase in the amount to be paid to the E.U. once they leave the Union, something analysts see as being supportive for Sterling near-term.

"GBP is up 0.3% from Friday’s close and outperforming all of the G10 currencies with the exception of NZD, climbing for a fifth consecutive session and testing fresh multi-week highs at levels last seen in early November. Brexit developments are providing support as market participants consider progress in negotiating the U.K.’s divorce bill," says Shaun Osborne, FX Strategist with Scotiabank.

In order for a deal on the UK’s post-Brexit relations with the EU to be struck, whether on trade or transition, Prime Minister Theresa May must agree to pay Brussels a “divorce bill” or overcome the EU’s insistence on a financial settlement.

Above: Pound-to-Dollar rate at daily intervals. Captures 2017 highs.

“The end-game is likely to be one in which both parties agree on a transition period so that the UK avoids dropping to the "void" from a cliff. Of course it is unlikely to be plain sailing, but once we get there, this is likely to manifest as a stronger support for Sterling,” says Gkionakis.

The UK government has said it wants to agree a transitional deal before discussions over the future trading relationship begin.

Downing Street’s reasoning is that an agreement on the future trading relationship may not come until the eleventh hour and so, if a disorderly exit is to be avoided, then an implementation phase must be agreed beforehand.

“Sterling volatility is likely to rise as the two sides continuously measure their bargaining strengths, potentially flexing their muscles with announcements and headlines hitting the market, occasionally causing confusion which ultimately generates volatility,” Gkionakis warns.

Brexit negotiations have so far been accompanied by a steady stream of news reports, claiming both deadlocks and breakthroughs, driving continued volatility in the Pound. 

Above: Pound-to-Dollar at weekly intervals. Captures before and after Brexit referendum.

December is seen as a critical time for the talks as if transition and trade are to be agreed before the end of 2018, in time for the resulting agreement to be ratified in parliaments across Europe, then talks on both need to begin by year-end.

“Additionally, and although economics will be an important driver for sterling these next couple of years, we believe politics will overshadow everything else,” says Gkionakis. “So, in the end, our forecasts amount to our best estimates about the process and the endgame of negotiations.”

Gkionakis notes the difficulty with assigning a value to Sterling in the current environment as, given uncertainty over the future economic landscape in the UK, modelling economic growth and valuing the currency involves more guesswork than is normally the case.

“The main problem is the lack of a valuation anchor, because we simply do not yet know the extent of the structural damage inflicted on the UK economy by the EU referendum result and the associated surge in business and household uncertainty,” Gkionakis says.

It could take some time before the UniCredit team, and other forecasters across the industry, have enough information to determine whether their valuation models will need to undergo a refurbishment.

“These past few months have shown the market thinks that levels between 1.30 and 1.33 embed a reasonable Brexit risk premium,” Gkionakis flags. “Insofar as an agreement on a transitional period reduces that premium, it becomes more likely that cable will gain traction above that level, converging and likely exceeding 1.40 in 1Q19.”

Gkionakis and the UniCredit team forecast the Pound-to-Dollar rate will reach 1.3700 before the end of 2018 and that it will trade up to 1.4200 by the end of 2019.

If realised, those forecasts would see Sterling recoup around two-thirds of its post-referendum loss before the UK actually departs the EU in 2019. 

The Pound-to-Dollar rate was quoted 0.30% higher at 1.3244 during the Monday session. It has traded as low as 1.1985 and as high as 1.3655 during 2017.

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