Capital Economics: Pound to find Support in 2018 as Bank of England Raises Rates Faster than Market Expects

The Pound could gain support over coming weeks on steady progress in the Brexit negotiations, while the Bank of England could reinforce the floor beneath the British currency in 2018 argue Capital Economics.

Recent developments in the Brexit negotiations are now seen clearing the way for talks to move onto the subjects of trade and transition from January.

The Pound has risen nearly 300 points against the Dollar and more than 200 points against the Euro since news of a breakthrough in talks first came in on Tuesday, and could go further still.

“Sterling’s jump since late Tuesday served as another reminder of the importance of the Brexit negotiations for the currency,” says Oliver Jones, an economist at Capital Economics.

Above: Pound-to-Dollar rate at hourly intervals. Captures reaction to Tuesday's news.

Wednesday, a Times report suggested the UK government and Brussels could be nearing an agreement on how to avoid physical infrastructure at the Northern Irish border.

European Council chief Donald Tusk and Irish Prime Minister Leo Varadkar will meet Friday to discuss the Republic of Ireland’s concerns over border issues.

This comes after Theresa May was reported to have agreed a methodology to calculate the so called “Brexit bill”, which could result in the UK making payments to Brussels worth close to €100 billion in total and €55 billion after adjustments and deductions are taken into account.

“Our assumption is that a transitional agreement with the EU is reached which largely preserves the status quo, and that a favourable agreement on the UK’s future trading relationship with the EU is eventually struck,” says Jones.

The recent “breakthroughs” clear two out of three of European negotiators’ demands, which had to be satisfied or overcome in order for negotiations on trade and transition to begin after December 14’s European Council summit.

“Admittedly, the road is likely to be bumpy,” Jones adds. “Ultimately, we think that sterling might receive some support as the overall negotiation process reaches a fairly positive conclusion.”

Above: Pound-to-Euro rate at hourly intervals. Captures reaction to Tuesday's news.

Markets had feared a delay to the start of talks because, if an eventual deal is to be ratified in all of the parliaments across EU member nations, then it would most likely need to be agreed by October 2018.

If it looks to be that a deal may not be reached in time, fears are that some financial services firms may begin shifting parts of their operations and staff out of London and into the European Union in order for them to continue operating on the continent.

2018: Interest Rates in Focus 

“In our view, though, the currency is more likely to be affected by the prospects for monetary policy in the UK and elsewhere,” says Jones. “With this in mind, we forecast that the Fed will tighten policy by more than markets are anticipating next year while most other major central banks keep rates unchanged.”

Capital Economics has pencilled a broad based rebound for the Dollar into its forecasts for 2018, which is seen being driven by tighter monetary policy in the wake of the implementation of the Trump administration’s tax cuts.

“However, we project that the Bank of England will be the only other major central bank to raise rates next in 2018,” says Jones. “And we think that it will tighten by more than investors expect too, as the UK economy weathers Brexit uncertainty and higher inflation a bit better than is widely anticipated.”

Capital Economics forecast three interest rate rises from the Bank of England during 2018, whereas the market has only pencilled in a single additional hike around the middle of the year.

The BoE could also hike twice in 2019, taking the bank rate to 1.75% by the end of that year.

“So, in contrast to other major currencies, there may not be much downward pressure on sterling against the dollar from this source,” says Jones. “Our end- 2018 forecast is $1.30/£, close to its level of $1.34/£ now.”

Capital Economics forecasts the Pound-to-Euro exchange rate will stay close to the 1.1400 level in the coming months but end the 2018 year around the 1.1800 threshold, its highest level since May 2017.

“Both our forecast and the market expectation is for the ECB to continue to make asset purchases up to end-2018, with a first rate hike unlikely until 2019,” writes Jonathan Loynes, chief economist, and team in a November note. “Moreover, we expect UK growth to rebound next year after underperforming the Eurozone recently.”

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