British Pound: BofAML see Short-Term Pain, Longer-Term Gains vs. Euro and Dollar

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- Strategists close trade that backed the Pound in anticipation of near-term weakness

- Warn May tends to be a poor month for Sterling

- Forecasts for 2018 confirm Pound remains undervalued vs. Euro and Dollar

One of the world's largest investment banks has confirmed a trade recommendation that sought to benefit from a rise in the Pound has gone wrong and near-term weakness should be expected. However, longer-term the Pound is still expected to trek higher.

Foreign exchange strategists at Bank of America Merrill Lynch (BofAML) have announced they have exited a trade that backed the Pound to rise over the course of April, in line with well-established seasonal trends that made such a call virtually fail-safe.

At the time of the trade's initiation we reported the BofAML view that "within the G10 FX complex, there is no stronger seasonality than in GBP through April" and "a combination of the end/start of the UK tax year and a heavy month of dividend payments by UK corporates are factors which we think are at play driving GBP strength during April."

The bet looked to be in the money with the Pound rallying over 2.5% to record a high of 1.4376, its best level against the US Dollar since Brexit Referendum evening in June 2016. The pair has since retraced the gains and five consecutive days of losses has resulted in a 2.64% slip.

The Pound meanwhile rallied to record fresh 11-month highs against the Euro at 1.1599. However, over the course of the past five days the Pound has fallen 1.5% against the Euro to trade at 1.1409.

The sudden capitulation in Sterling comes as markets unwind some of the hefty positive positioning in Sterling that has built up over recent weeks with data showing markets to have been the most bullish on the Pound since 2014. When positioning reaches such extremes the prospect of a reversal becomes elevated in order for the market to restore balance.

The trigger to the selling proved to be a slew of under-par data and a warning by Bank of England Governor Mark Carney that the Bank might not in fact raise interest rates again in May; something that markets had been bidding the Pound higher in anticipation of.

And more losses could come over the near-term as BofAML warn that May tends to be a month of poor performances in Sterling owing to seasonal factors and they would anticipate a "correction" lower as a result. 

Still constructive on GBP Longer-Term

While the capitulation by Sterling-bulls has left strategists licking their wounds, BofAML "remain constructive on GBP over the medium-term maintaining the British Pound can go still go higher, with valuation being a particularly important basis for the call.

"We reiterate that GBP has rarely been undervalued for this time of the business cycle. Furthermore, our constructive view on the Brexit negotiations also support medium-term GBP upside as the tail risks of a disruptive exit continue to fall and customs unions arrangements cannot be ruled out," says Athanasios Vamvakidis, an FX Strategist with Bank of America Merrill Lynch.

With regards to the economy and Bank of England policy, BofAML say despite some softness in UK data, the Bank of England MPC appears to be willing to deliver further policy tightening and they fully expect a 25bps rate hike at the May monetary policy meeting.

It's not just BofAML who are expecting a better performance by Sterling on the basis of Bank of England policy.

"Despite reaching a post-Brexit high, it's been a pretty dismal week for GBP - with a string of UK data misses and cautious policy comments dramatically weighing on the currency. Our call for a May BoE rate hike remains intact," says Chris Turner, an analyst with ING Bank N.V.

With the market-implied probability of an interest rate rise being delivered in May having slumped to below 50%, "we think a decent GDP print reviving a 'buy the BoE rate hike rumour, sell the fact' price action in GBP markets," adds Turner.

Forecasts for Sterling

BofAML say the Pound is undervalued by about 15% and the Pound-to-Dollar exchange's fair-value level is up at 1.62. However, the official year-end target resides at 1.41.

The investment bank's year-end forecast target for the Pound-to-Euro exchange rate is meanwhile located at 1.1765.

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Quantitative Signals Positive on GBP

BofAML's quantitative studies are also positive on Sterling with their models - which take note of technical factors - indicating a higher GBP.

Looking at current FX positioning and trends, analysts applied their Moving Average Aggregator model (MAA) to GBP on its G10 crosses and in all nine cases the MAA is above 60, meaning there is an uptrend.

"Thus, GBP is likely to strengthen further, but isolated corrections are possible. One such correction could occur in May where GBP/USD has generally underperformed since 2010," say BofAML.

Why Maybank are Also Constructive on the Pound

Technical analysts with Far-East focussed investment bank Maybank have meanwhile confirmed their models are pointing to the potential for some near-term decline in Sterling.

"Brexit uncertainty could slow the pace of interest rate rises. GBP was last seen at 1.4030 levels. Daily momentum has turned mild bearish while stochastics is falling. Further downside play not ruled out. Support seen at 1.4020-40 levels before 1.3960," says Saktiandi Supaat at Maybank's Singapore offices.

Yet while Supaat respects the momentum lower, he maintains a bias "to buy on dips".

"We retain our broadly “more optimistic” outlook than street consensus for GBP on the back of our expectation for orderly Brexit (boost to sentiment), continued improvement in labor market (upward pressure for wage growth providing room for BoE to tighten) and potentially greater tolerance (from policymakers) for GBP appreciation (to help curb imported inflation) and rising market expectation for BoE rate increase to come earlier than expected," says Supaat.

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