The GBP/USD Rate Has Further To Fall: J P Morgan

Analysts at the world's largest investment bank are looking for Pound Sterling to edge lower still against the US Dollar.

The Pound to Dollar exchange rate is said to overvalued at current levels and therefore a prime candidate for selling says J P Morgan strategist Paul Meggyesi in a recent note seen by Pound Sterling Live.

Meggyesi reaches the conclusion after comparing Cable’s current rate of 1.2257 to its estimated ‘fair value’ of only 1.1500.

The ‘fair value’ is based on the bank’s model which mainly factors in the yield differential between the countries respective two year bonds and are used as a proxy for measuring interest rate expectations.

When a country’s interest rates are expected to rise versus a counterpart that country’s currency will rise due to attracting more capital inflows from investors seeking higher interest returns.

The discrepancy between the model’s true value estimate and the actual rate is quite sizeable and could suggest the Pound is grossly overvalued.

“Cable is the most over-valued G10 currency versus the dollar. Indeed, cable is more expensive versus 2Y rate spreads than at any point in the last five years. Fair-value currently languishes at 1.15, more than two sigma below the spot rate (chart 6). GBP is consequently one of the most attractive currencies to sell for an extension of the dollar’s interest rate rally,” says Meggyesi.

The 'sell cable' recommendation fits with Meggyesi’s thesis that the US Dollar has higher to go as the Fed looks more certain to increase interest rates in March and this will have the effect of increasing expectations of more frequent future rate rises than are currently priced in.

“While a March hike is now as fully priced as appears likely before the actual meeting, the Fed broader repricing cycle for the dollar at first glance might have much further to run,” said Meggyesi.

“But if a hike is indeed confirmed on March 15th, rates markets likely feel comfortable in pricing in the schedule for the next two hikes on a path towards cumulative 75bps in 2017,” added the Strategist.

The upshot of all this for the Dollar would be to encourage another substantial leg higher of over 3.5%.

“If markets were to price in 3 more hikes over the following 12 months, this could push the dollar index 3.5% or more higher than where it is today, or in other words new highs for the cycle,” said Meggyessi.

About 1.0% of that 2.5% expected run higher is due to the Dollar already being undervalued according to interest rate expectations, as measured by yield spreads.

Domestic Concerns to Weigh on Sterling

Meggyesi says there are three other reasons why GBP will fall.

Firstly, the UK economy is now clearly slowing in response to higher inflation - stemming from higher global energy prices and the impacts of the slide in Pound Sterling which has raised the cost of imports and weighed on consumer confidence.

UK growth in 1Q17 is expected to be only half the 2.9% recorded in 4Q16. High hopes for Bank of England rate hikes this year have therefore been crushed and until markets start pricing in an interest rate rise from current record-lows at the Bank of England, Sterling will likely struggle.

Secondly, the government is on course to trigger Article 50 by the middle of the month despite a setback in the House of Lords. It is then that the economy will begin to feel more acutely the impact of Brexit

“Investor confidence is vulnerable as it should become apparent relatively early into the formal negotiations that the UK is on course for a harder Brexit with all of the economic disruption that leaving the single market is likely to entail,” says the J P Morgan strategist.

Thirdly, there is a growing political and constitutional threat from Scotland.

The Scottish National Party is expected to argue at its conference on March 18-19 that another referendum on independence should be held.

The UK government is expected to resist such a call for now, but investors will be reminded that the break-up of the UK is a high-probability consequence of the UK’s decision to leave the EU, nevertheless, whether this ends up being positive or negative for the economy may remain to be estimated.

At the last referendum, it was calculated that the UK economy would probably not suffer as much as was thought from a breakup, and Scotland does get disproportionately more revenue than the UK, making it something of a costly enterprise to maintain.

Of course, the price of North Sea oil may well be a factor in the calculation and so much may depend on the future trajectory of oil prices.

Finally, the Chancellor’s budget on Wednesday, March 8 may be a factor impacting on the British Pound.

Hammond has been very clear that he is not about to embark on a “spending spree” despite calls to.

Hammond wrote to the Sunday Times saying, "while we are making steady progress in eliminating the deficit, there are still some voices calling for massive borrowing to fund huge spending sprees. That approach is not only confused, it's reckless, unsustainable and unfair on our young people who would be left to deal with the consequences."

This contrasts with the US fiscal approach which is much more reflationary and where markets expect to see a 1 trillion spending spree in America on the back of Donald Trump’s infrastructure policies.

Markets bet that this will stimulate growth.

Such an extreme divergence in fiscal stance between Britain and America is bound to feed through to GBP/USD and see the UK side of the pair lose ground.

Of course, the long-term implications are hard to tell as one would assume the country with a more sustainable debt load would command a stronger currency in the long-term.

For now though, spending = good when it comes to currencies.

As such, even though the UK budget so often has little impact on Sterling, this time may be an exception.

To conclude, J P Morgan’s trading recommendation is to short sell GBP/USD if it moves below 1.2250, placing a protective stop at 1.2530.