Pound-to-Dollar Exchange Rate Could be Headed to 1.40: BMO Capital's Gallo

Above: Stephen Gallo, BMO Capital Markets.

The GBP/USD exchange rate could now be on course to its highest level since before the Brexit vote of 2016 we are told.

Sterling's multi-month uptrend found renewed vigour mid-week following the latest developments in the Brexit negotiations, although hurdles remain and the road ahead could be a bumpy one.

Brussels’ negotiators have been instructed not to discuss future ties with the UK until the financial settlement and issues around citizens rights and the Northern Irish border are agreed, this means the much-needed clarity required by businesses concerning the future remains unclear.

This has in turn held back investment and seen investors discount the value of the Pound; only clarity on the future trading relationship will ultimately allow this undervaluation to correct.

Hints of progress were forthcoming Tuesday on reports the U.K. Government has settled on an amount they are willing to pay to secure a financial settlement, or a “Brexit bill”.

This is the first in a number of steps that should progress negotiations, and in turn aid a recovery in the Pound.

“GBPUSD should trade with a firm tone throughout today and probably for the balance of the week, and the pair may have scope to break back above 1.3500 in the near-term,” says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

The move is seen clearing the way for Brexit talks to progress onto the subjects of trade and transition after the European Council summit of December 14, as well as having positive implications for domestic politics.

“The outcome should reduce the risk of a snap election in the UK because it gives the opposition Labour party one less element of Conservative weakness to feed off of,” says Gallo.

Progress in Brexit talks could also pave the way for interest rate derivatives and bond markets to bring forward the point at which another Bank of England rate hike becomes implied. This would provide additional support to Sterling.

The Pound-to-Dollar rate will head to 1.40 over the next 6-12 months, according to BMO forecasts, but the strategy team warned Wednesday that there are still hurdles the Pound must overcome to get to higher levels.

Above: GBP/USD shown at weekly intervals. Captures referendum reaction and recent trading.

“The FX market will want to see definitive progress on trade and transition over the next 2-3M and the UK government will have to overcome the potential for divisions within CON regarding the shape and length of the transition,” says Gallo.

In the short term, the 1.3500-1.3600 range is an area where Pound-to-Dollar traders should become cautious although, on a medium-longer term basis, the Pound remains undervalued for several reasons.

“The trade-weighted GBP is already cheap on a number of metrics,” says Gallo. “The path of least resistance for the GBP, due to any type of market-friendly political developments, is therefore up.”

The BMO team flag the trade-weighted Pound as being cheap relative to its fundamentals, which are dictated by the current account and trade deficits, while on a purchasing power parity basis, it also screens as cheap.

“In GBPUSD, my view is that the developments overnight will help keep the uptrend intact, paving the way for the pair to track any incipient strength in EURUSD more closely,” says Gallo.

An agreement to move Brexit talks onto the subject of trade and transition at the December summit is seen as important for the UK because, without this, fears are that some financial services providers may move some operations and staff out of London sooner than they would have otherwise.

There are more than 800,000 people employed in the financials services industry in London and, at the national level, more than 2 million work across the sector according to lobby group The City UK.

While the numbers likely to be affected by moves over to the continent are only a very small fraction of this total, it is thought the government will be keen to avoid any harm to the sector.

The December deadline is key for markets because, if a trade and transition agreement is to be ratified in all of European Union member states' parliaments before the date the UK leaves the EU in March 2019, a deal needs to be struck before October 2018.

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