Strategists eye British Pound Weekness into Year-end, Recovery seen in 2019

© Anthony Brown, Adobe Stock

- Sterling a sell with UBS and Deutsche Bank

- Brexit deal is still the market's favoured likely Brexit scenario

- Pound-to-Euro exchange rate @ 1.12 today, Pound-to-Dollar @ 1.3177

Betting on a decline in Sterling over coming weeks remains a popular choice with foreign exchange strategists at some of the City's leading investment banks who believe the currency will remain under pressure as Brexit negotiations approach their end-game.

The Pound will underperform against rivals over coming months as the deadline for a Brexit deal approaches and markets fret over whether an accord will be reached suggest analysts at UBS.

Nerves will remain elevated as the consequences of a 'no deal' for the currency are substantial. Sterling will fall to a fresh nadir against the Euro and multi-decade trough relative to the Dollar if the U.K. departs the EU without a transition agreement in place or a deal ensuring continued free trade with the bloc, the Swiss banking giant says.

While UBS are in line with market consensus in assuming that a deal will be reached, the threat of failure is a notable risk that will weigh on the Pound until solid progress materialises.

The chief investment team are therefore advocating that clients bet against the Pound-to-Dollar rate in order to exploit Sterling's anticipated poor performance.

"Sterling continues to work as the shock-absorber. The spectre of material short-term damage to the economy in case of a "no deal" keeps Pound investors on their toes," says Daniel Trum, a strategist in the chief investment office of UBS, in a recent note to clients. "We thus expect the British Pound to be one of the weakest G10 currencies over the next three months. Our short-term recommendation, to go short GBP against long USD, targets 1.26."

Trum has a stop-loss at 1.335 and says the investment horizon of for the above trade is one-to-two months, suggesting he and the UBS team do not expect the Pound-to-Dollar rate to rise above that level in the near future.

UBS' call comes alongside a change of tune from Deutsche Bank, whose analysts advocated Monday that clients sell the Pound-to-Euro exchange rate in order to hedge themselves against the risk of a deterioration in the Brexit negotiations. 

Deutsche Bank note that the performance of the U.K. economy should command a stronger Pound, but near-term uncertainties will weigh into year-end.

"We recommend buying EUR/GBP to hedge against an increasing deterioration of Brexit negotiations," says Harvey.

Above: Deutsche Bank analysis shows that on a Purchasing Power Parity basis the Pound is at fair-value against the Euro. (What is Purchasing Power Parity?). Image courtesy of Deutsche Bank.

Both banks have eyes on not only on negotiations over the U.K.'s withdrawal, which stalled last week following a seemingly disastrous E.U. summit in the Austrian city of Salzburg, but also on the tricky dynamics in Prime Minister Theresa May's parliamentary party.

Assuming P.M. May emerges from the other end of the Brussels gauntlet with some kind of agreement, strategists are unsure over whether she will be able to secure enough votes to get it through the U.K. parliament.

Failure to secure a deal, as well as have it approved by parliament, would almost certainly mean an immediate exit from the EU and default to trading with the bloc on World Trade Organization terms.

"If a no-deal scenario were to transpire, it is likely that the hit to the economy will be substantial until factors can adjust," says Trum. "We think that GBPUSD could experience new multi-decade lows in the area 1.10-1.15, while EUR/GBP may temporarily shoot above parity. Such levels should be difficult to sustain though."

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Base-Case Assumptions Hint at Recovery

However, for all of the warnings about the dangers of a 'no deal' scenario and accompanying losses for Sterling in the short-term, both banks are forecasting that a withdrawal agreement will be reached in good time and passed by parliament as a minimum.

May has herself said that a general election will not solve anything, and her calculations assume opponents to her Brexit plans within her own party will ultimately back her at the last minute.

UBS says this could open the door to a recovery by the British currency from its current steep undervaluation.

"Setting doom and gloom aside and looking at the base case of a withdrawal agreement, the outlook for the pound is actually relatively rosy," says Trum. "The BoE would be on track to normalise monetary policy further, eyeing the next possible rate hike in 2019 or 2020. A generally strong global economy should rekindle demand for undervalued currencies like EUR and GBP, against the overvalued USD."

Trum and his chief investment office colleagues suggest that a deal on withdrawal, which means a status quo transition period until at least the end of 2020, will push the Pound-to-Dollar rate to 1.36 and higher while driving the Pound-to-Euro rate above 1.1360 over the 12 subsequent months. 

Officials from both sides of the English Channel are seeking a withdrawal agreement ahead of the October European Council summit, although some have said an extraordinary meeting could be arranged in November if a deal is not struck the previous month. 

The deadline is important because even once a deal is done, it will still have to be signed off by the Council and approved by all parliaments in the European Union. This itself will take time but the Article 50 process governing the Brexit exit currently only provides until March 29, 2019 before the U.K. automatically leaves the EU. 

However, disagreement over how to manage the Northern Irish border in the event a trade deal is not agreed at a later date is standing in the way of a deal. 

The EU's current Irish border proposal of customs union membership and continued "regulatory alignment" for Northern Ireland would mean either all of the U.K. remaining inside the EU customs union and single market, or a de-facto sea border being installed between the island of Ireland and Great Britain. The latter is something PM May has said "no U.K. Prime Minister could ever agree to".

Positive Developments Cement Sterling Near-Term

Pound Sterling was the best performer among the major currencies for a second straight session on Tuesday, buoyed both by monetary policy signals and some encouraging signs around Brexit.

Sterling got an initial lift from the Bank of England policy-setter Gertjan Vlieghe, who said his own forecast is for 1-2 rate hikes per year.

"This was somewhat more hawkish than market pricing, which currently sees the next 25 bps hike being delivered in August 2019," says Andreas Georgiou, an Investment Analyst with XM.

Georgiou notes Sterling firmed further amidst media reports suggesting E.U. negotiators are willing to offer the UK a “free-trade area” after Brexit, but contrary to Chequers, there should be a customs border that would involve some “friction” on trade.

More importantly, the EU is prepared to make a “special case” of Northern Ireland given its small population and allow it to be one of these free trade areas – though extending this to the entire UK would give it an unfair advantage.

"While there wasn’t much further detail, the mere fact the EU seems ready to make some concessions on the Irish border issue is encouraging by itself, potentially laying the groundwork for some progress in the coming weeks," says Georgiou.

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Lock in Sterling's current levels ahead of potential declines: Get up to 5% more foreign exchange for international payments by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here