British Pound Overvalued in the Face of "Binary" Risks says Algebris's Gallo

- Complacent markets are mispricing the risks to Sterling

- 'Hard Brexit' or Labour government could lead to emergency financial measures

- Yet Blackrock sees risks easing as May has numbers to survive a challenge

Image © Pavel Ignatov, Adobe Stock

Pound Sterling has held its ground surprisingly well this week despite the shock of multiple ministerial resignations following the announcement of the Prime Minister's new Brexit plan, and the end to ministerial freedom of conscience on membership of the EU that the plan demands.

The Pound-to-Euro exchange rate is seen trading back above the 1.13 level having plumbed lows down at 1.1232 in the wake of news that Foreign Secretary Boris Johnson was resigning his post in government.

The Pound-to-Dollar exchange rate meanwhile holds above 1.32 and with it most of its July advance.

Reassured by its robust response, analysts are reading the inert Pound as a sign of confidence by markets that Theresa May and her government will remain intact and continue to offer certainty to markets.

However, this complacency might be dangerous and the Pound is therefore potentially overvalued says Alberto Gallo, a portfolio manager at Algebris Investments who argues the market is underestimating the risks to the Pound, which have become dangerously polarised of late.  

These "binary" risks include a hard Brexit and a Jeremy Corbyn government.

In the case of a cliff-edge Brexit, the financial shock would probably lead to emergency measures, such as money-printing and quantitative easing enacted by the Bank of England in an attempt to soften the blow.

In the event of the May administration falling and the election of a Corbyn government the accompanying sharp rise in public spending would necessitate an acceleration in public borrowing.

"There is a serious risk that the UK will have to print its way out of trouble because they will have to issue more debt," says Gallo.

Sterling's inexplicable strength in the face of such risks is therefore due to market complacency it is alleged.

"Short-term the market is too comfortable, we think that the Pound is mispriced and also the Bank of England is mispriced," says Gallo, adding, "the market thinks the Bank of England will hike once this year and once next year. We think that is wrong. In this uncertain environment with potentially a fall in the government, we don't think the Bank of England can hike rates."

Bets for an August interest rate rise rose sharply following the Bank of England's June policy meeting that saw three members of the Monetary Policy Committee vote for an immediate interest rate rise. Subsequent communication from the Bank has cast confidence in the economy's ongoing recovery from a soft start to the year leading expectations for a rate rise on global money markets to stand at around 70%.

The Pound firmed alongside growing expectations.

But, Sterling's true value lies much lower says Gallow, down in the 1.20s versus the Dollar.

Due to the heavy environment of uncertainty Gallo thinks the Bank of England could forego an expected rate hike in 2018 and possibly even in 2019.

Since higher interest rates tend to drive up the value of a currency by attracting more inflows of foreign capital drawn by the promise of higher returns, the expected delay in raising interest rates would have the opposite effect - and weaken the Pound.

"We think the Bank of England could go on hold rather like the European Central Bank has done, rather than continuing to hike one or two times over the next two years," he says.

Other analysts have played down the risks to the government.

Rupert Harrison, a multi-asset portfolio manager at Blackrock, says that the strong Pound is a reflection of expectations that the government will eventually execute a 'soft' Brexit along the lines of May's new plan because of a realisation that no-deal is "not an option for the UK and therefore if they are going to get a deal they are going to have to make some compromises".

He says that May is probably still safe as party leader because the Brexiteers have enough support to issue a leadership challenge but not enough to win one since they need more than half of the 316 conservative MPs, which they probably don't have.

"Lyndon Baines Johnson's first rule of politics is "you have to know how to count," and I think the crucial thing at the moment is that Theresa May has the numbers. I think that the Brexiteers in her party know they have enough numbers to challenge her but she has enough numbers to win that challenge and stay in place," says Harrison.

Conservative party rules mean a Prime Minister can only be challenged once per year and this may be another factor protecting the Prime Minister. Brexiteers will not want to mount a challenge unless they are sure they can win as otherwise they will have wasted their bullet and will then have to wait till 2019.

"That's another factor holding the Brexiteers back. They won't want to mount a challenge which fails and I think they are going to bide their time and see if there is another opportunity to see if they can change their policy," says Harrison, talking on Bloomberg.

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