The Pound Forecast 9% Higher Against the Dollar, But Euro Won't be Such a Pushover say UniCredit

Unicredit Tower A, Milan © Sergio Fabio Brivio, Flickr, Reproduced Under CC Licensing

Pound Sterling can deliver further strength against the Dollar over coming months, but anyone hoping for such an advance against the Euro might be disappointed.

European banking giant UniCredit have embarked on a study to find out whether the British Pound offers any value to investors as markets are confronted by predictably tenuous Brexit negotiations once more.  

Roberto Mialich, an FX Strategist with UniCredit Bank in Milan has sought to answer the question of whether "there is life - i.e. value - in Sterling" and his findings confirm the outlook for the currency remains as complicated as ever with some pairs offering upside, and others not so much.

The findings of Mialich's research show that, "yes, there is life in GBP/USD, but only because the USD is set to weaken further" while he "does not see – at least for now – much life in EUR/GBP".

In all, UniCredit are "not big supporters of Sterling right now," citing British economic growth that is likely to remain the lowest in the G7 also this year, while the Bank of England's decisions on interest rates are also unlikely to offer a boost to the currency. And, most importantly, "Brexit talks represent a brake for any sustained Sterling strength."

Yet, there is the prospect of some 9% appreciation in the Pound against the Dollar which confirms UniCredit believe the positive outlook for the Pound-to-Dollar exchange rate is almost purely a Dollar story, and nothing necessarily to do with Sterling strength.

Above: The GBP/USD (inverted in the above) is tracking the broader Dollar (DXY)

UniCredit believe the US Dollar to be undergoing a longer-term correction from being overvalued, and the GBP/USD has now risen close to a fairer valuation from having been undervalued.

"In our view, the USD, which has rapidly closed its overvaluation gap, will weaken further this year, primarily on the back of the reshuffling of flows outside the US and with the expected increase in the US budget deficit representing an additional drag," says Mialich.

Above: The difference between interest rate yields in the US and UK are used to derive fair-value for GBP/USD

GBP/USD fair-value is currently placed at 1.36 by UniCredit models, the current spot is close to 1.375. But, it is UniCredit's view that this fair value will rise over coming months.

Furthermore, the Pound's rally higher will be greased along by a favourable structure to the foreign exchange market in that market positioning is seen as balanced, i.e. the exchange rate could move higher as it is not constrained by a 'crowded trade'. In short, when the market is involved in a one-way bet a move can slowly die as there are simply no enough fresh entrants joining the trade to push it along.

We reported this week that a trend of paring GBP longs has continued leaving markets still bullish on the currency, but they are not as enthusiastic as they once were.

"A weaker USD ahead, as we expect, can lift Sterling and we stick to our forecast at 1.50 for GBP/USD by year-end," says Mialich, "but we doubt that Sterling will outperform most major FX, while we expect it to struggle against the Euro."

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Downside Ahead for the British Pound Against the Euro

The EUR/GBP exchange rate is, on the other hand, almost purely being driven by the perceived risks surrounding Brexit, and understandably there is too much uncertainty surrounding negotiations to prompt a Sterling-favourable outcome.

That doesn't mean it's all doom-and-gloom however as UniCredit reckon there could be some strength against the Euro should a transition deal be agreed between the EU and UK at the  March 23 summit.

"In the near term, Sterling can benefit if the transition agreement is reached at the 23 March EU summit, as we basically expect, and trade talks can start thereafter, while a failure will be extremely damaging," says Mialich.

The call comes at a particularly tense time for the EU and UK with issues concerning the Irish border flaring up once more in the wake of the publication of a legal text by the EU that seeks to keep Northern Ireland in the single-market and customs union should a viable solution to ensuring no hard border is erected on the island of Ireland be found.

The EU believe no viable solution has yet been put forward, Prime Minister Theresa May has meanwhile warned no UK Prime Minister could accept the creation of a border within the UK which would result were Northern Ireland to remain in the customs union and the rest of the UK leave.

"UK/EU trade negotiations remain tough, so that the 'Brexit risk premium' will likely continue to play against more GBP strength against non-USD currencies, and primarily the euro, until signs of a clear breakthrough toward a final deal emerge," says the analysts.

What's the Brexit risk premium? Simply put, this is the difference between where the exchange rate is now and where it should be if it were being driven purely by economic determinants. In short, the Euro is overvalued against the Pound:

But, because a currency is undervalued it doesn't necessarily mean that it can't become even more undervalued and a sudden drying up of foreign investment inflows into the UK could hit the Pound hard, as was the case during the 2008 financial crisis. Recall, back then the Pound-to-Euro exchange rate fell to its lowest ever exchange rate at 1.04 (according to BoE data).

"Signs that Brexit negotiations hit new hurdles can impact the direction of UK portfolio flows, as happened on the back of the Brexit referendum in June 2016, and put sterling under strain again," warns Mialich.

And, the Bank of England is unlikely to be a positive influence as markets have priced two interest rate rises into the Pound over the next year. Getting a more aggressive rate raising path than that squeezed into the markets is hardly likely.

UniCredit are therefore forecasting the Pound-to-Euro exchange rate to be around 1.11 by end-2018.

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