Pound Sterling can Recover Against the Dollar, Euro say Capital Economics

• Pound to Euro exchange rate: 1 GBP = 1.1475 EUR
• Pound to Dollar exchange rate: 1 GBP = 1.2815 USD

Good news for those readers yearning for a stronger British Pound.

After weeks of reporting increased levels of bearishness on the British Pound amongst the analyst community we can finally report someone has turned more positive.

A new analysis of the Pound suggests the outlook is positive and some of the recent strength we have seen can actually extend.

Analyst Jonathan Loynes at Capital Economics - the independent research consultancy - has told clients that “while the pound could fall again if the economy weakens or Brexit prospects worsen, there are good reasons to think that its recent appreciation can continue.”

Loynes says the economic outlook remains supportive of a stronger currency.

Capital Economics stood head and shoulders above others in the analyst community when they said the Brexit vote wouldn’t have a massive negative impact on economic growth.

They were right, and those who were calling recession in the aftermath of the Brexit vote were proven wrong.

Capital Economics argue that their prediction that a substantial decline in the Sterling exchange rate would help to cushion the blow to the economy if the UK voted to leave the EU has been borne out since last June.

They say the near 15% trade-weighted depreciation has clearly helped to support activity in the export-related sectors.

The call does come on the day the ONS gives their final estimate for economic growth for the first quarter of 2017 which shows growth was lacklustre at best.

Furthermore, there was a massive downgrade to the contribution made by trade to UK economic activity which would contradict the call by Loynes.

That said, the data from the ONS was for the first quarter and does not encompass the entire post-EU vote period.

Analysts do also say exports should provide a decent fillip to quarter two growth.

The Pound’s fall has had notable negative effects on the UK economy as it has raised  imported inflation and had a corresponding squeeze on consumers’ real incomes.

“But we think that the net effects of the deprecation will be closer to those after  Sterling’s 1992 ERM exit than those after the drop seen during the financial crisis,” says Loynes.

The analyst adds:

“Looking ahead, the Pound will no doubt continue to act as a valuable shock-absorber should the economy weaken or the Brexit negotiations take a turn for the worse. However, there are reasons to think that Sterling’s post-referendum depreciation may continue to be reversed.”

Three Reasons Why the Pound Will Recover

Loynes cites three reasons why he believes the outlook favours a more protracted recovery in the UK currency:

1) Despite Q1’s growth slowdown, expectations of the UK’s relative economic performance could strengthen further.

As Chart 1 shows, the Pound’s re-appreciation thus far has been supported by the recovery in consensus forecasts for GDP growth this year. But expectations for growth next year have remained depressed. That will surely change if, as we expect, the economy remains resilient in the coming quarters. And that, in turn, would probably shift expectations of the future path of interest rates.

2) Notwithstanding the uncertainties over its final form, there is growing optimism that the road to Brexit might be less bumpy than previously feared. Of course, that could change quickly, perhaps if expectations of a much increased Conservative majority after the general election are not met. But there is also scope for a further reduction in Brexit fears if the negotiations proceed relatively smoothly.

3) The Pound may (ironically) benefit from further strength in the Euro-zone’s economy and currency. We now expect the Euro to rise further against the US Dollar as growth in the currency union surprises on the upside.

While that might mean that the Pound falls against the Euro, Chart 2 shows that it has recently been much more closely correlated with the single currency than with the Dollar:

Forecasts for the Pound Against the Dollar and Euro

Given all this, Capital Economics have raised their forecasts for the Pound against the Dollar.

They now expect GBP/USD to end this year at $1.30 (previously $1.20) before rising to $1.35 by end 2018 ($1.30) and $1.40 by end 2019 ($1.35).

They expect the Pound to remain fairly close to current levels against the Euro.

This view on the Pound to Euro exchange rate is similar to that held at Lloyds Bank, something we reported on earlier this week.