British Pound has 3-5% Upside Potential as Brexit Transition Deal Opens Door to Interest Rate Rises

- Notable potential for UK economic growth to accelerate no Brexit transitional deal done

- 3-5% Sterling appreciation in trade-weighted terms this year say ING

- But UniCredit warn transitional deal is no game-changer for GBP/EUR

© Goroden Kkoff, Adobe Stock

The Pound remains “extremely cheap” and with a Brexit transition deal now in the bag, fading economic uncertainty should create scope for the British currency to regain its poise against the Euro and US Dollar, according to strategists at ING Group.

This call comes hours after British and European negotiators agreed a deal to extend the status quo for 21 months after the March 2019 Brexit date. The agreement was reached after issues covering citizens rights and a financial settlement were agreed in full while the Northern Irish border question remains open, but enough assurances on the issue have been provided to allow negotiators to recommend talks progress to the third stage.

The March 19 outcome that saw the EU and UK strike a deal on transition "will go some way to alleviating the short to medium term uncertainties surrounding the UK economy,” says Viraj Patel, an FX strategist at ING Group in London.  

Most importantly for businesses, the deal removes or at least defers the risk of a so-called cliff edge Brexit, where the UK leaves the EU immediately after an agreement reached in the dying hours of March 2019 or leaves without an agreement an agreement at all and defaults to trading with the EU under World Trade Organisation terms.

The Pound rose sharply against the Dollar, Euro and all of its other developed world rivals in response to the deal agreed Monday.

This saw Sterling break back above the 1.40 level against the Dollar while traversing its way toward the higher end of its five-month trading range against the Euro, with the Pound-to-Euro rate having been quoted as high as 1.1434.

Above: Sterling is moving back towards the top of a long-held range against the Euro after nine consecutive days of gains

“We believe that GBP’s re-pricing of Brexit transition optimism is now complete – and revert our attention back to UK economic fundamentals to determine the scope and extent of any GBP appreciation over the coming weeks,” Patel writes, in a note Monday.

Now, with the climactic agreement on transition now fading into the market’s proverbial rearview mirror, all eyes are seen returning to UK fundamentals, at the outset of a busy week for economic data.

Patel believes the Pound can now regain its "cyclical swagger" a reference to the observation that the UK economy is not performing at its full potential, an idea neatly encapsulated by this graphic provided by Swiss bank Julius Baer:

The graph shows economies naturally evolve in a series of peaks and troughs, performing below and above potential. Brexit uncertainty has ensured the UK economy has underperformed potential for some time now. But remove that uncertainty, and the prospect of an improvement towards potential becomes positive.

This has implications for UK interest rates, and the exchange rate.

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Door Opens to Bank of England Hikes, and a Stronger Sterling

Tuesday brings the latest reading of the UK’s inflationary pulse while Wednesday will see the Office for National Statistics release the latest volley of UK labour market data.

Both sets of figures will offer are crucial inputs into the Bank of England’s view on the economy, which will be front and centre on Thursday when the central bank announces its latest interest rate decision.

“If all the cards were to fall perfectly into place – and we also see a status quo hawkish Bank of England policy message and constructive UK wage inflation data – then we would not rule out a sharp move in GBP/USD up towards the year-to-date highs around 1.4250-1.4300,” Patel says.

The BoE warned in February that it will raise interest rates faster than markets had been expecting if the inflation outlook evolves in line with its latest set of forecasts. It projects the consumer price index will remain above the 2% target until at least the end of the first quarter 2021.

Few economists expect the Bank to raise rates in March but the latest developments could inject a more hawkish bent into the BoE’s rhetoric this week, which would have positive implications for Sterling.

In short, the Bank now believes the removal of some Brexit-related uncertainty should allow the economy to expand at a more robust pace, and therefore it will be more at risk of overheating, hence the need for higher interest rates.

Pricing on global foreign exchange markets suggest the odds of a May rate rise - and further subsequent rate rises - have risen over the past 24 hours.

And the prospects of higher interest rates spell for a stronger Pound.

Research from Swiss-based global investment bank UBS finds that Sterling valuations remain tightly correlated with monetary policy expectations i.e. that Brexit uncertainty is reflected in the value of the Pound via Bank of England expectations, therefore the dial on interest rate expectations must move before the Pound does

"As a result, most of the upside for sterling is likely to arise from the more traditional channel of rate differentials rather than risk premium unwind," says Lefteris Farmakis at UBS.

UBS calculate for every 25bps of additional rate hikes priced in for the BoE vs ECB, the GBP/EUR exchange rate rises by c.2%.

"The repricing of the relative policy stance by a modest 25- 50bps is fairly plausible, in our view. Accordingly, sterling could gain by up to 4% vs EUR," says Farmakis, implying an upper-bound for GBP/EUR at around 1.1760.

ING meanwhile forecast the EUR/GBP exchange rate will trade within a range spanning the 0.85-0.90 levels over the coming year, which translates to a Pound-to-Euro exchange rate of 1.1235 to 1.1764.

Patel says the Pound is also likely to move higher against the US Dollar.

“Our base case remains for GBP/USD to move up to 1.45 as the UK economy regains some of its cyclical swagger – but we do think that patience may be required before investors look to take that bet,” Patel adds.

Further hawkish signals from the BoE and positive data from the UK economy will likely be required if markets are to bet more boldly on a rate hike in the short term.

“Bottom line: Risk-reward suggests that an extremely cheap GBP has greater room for a cyclical recovery over 2018 (we still look for a 3-5% Sterling appreciation in trade-weighted terms this year),” Patel concludes.

However, expectations for a materially stronger Pound might not be met with some analysts pointing out the recent transition deal announcement is good for the currency, but is not necessarily a game-changer, particularly versus the Euro.

Economist Chiara Silvestre with UniCredit Bank in Milan confirms the announcement on a Brexit transition is "good news that should support the currency over the medium term" but reminds clients that the Euro is also likely to remain supported by the positive economic narrative in the Eurozone.

As a result, the GBP/EUR exchange rate is expected to remain "relatively stable" and it "looks unlikely to break out of its established range which is identified as being between 1.15 and 1.11.

Therefore, 1.15 could be as good as it gets and the long-term sideways trend remains intact.

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