Rabobank Forecast Pound-Dollar Rate Lower Still

- Rabobank maintain broadly constructive view of the US

- See short-term pains for British Pound

- But, hold a constructive longer-term 12-month view of the Pound

© Cyclone Bill, Reproduced under CC licensing

The Pound-to-Dollar exchange rate has fallen steeply over recent weeks and further weakness is likely as the outlook for the Pound sours whilst that of the Dollar conversely brightens, says Jane Foley, senior FX strategist at Rabobank.

Analysts at the Dutch-based multi-national do however foresee Pound Sterling recovering on a longer-term basis as the bones of a future trading partnership between the UK and EU materialise and the Dollar's newfound growthspurt fades.

The Dollar had previously weakened against the Pound on expectations that global growth would catch-up with the US and investors would be attracted by the better investment opportunities offered by the 'Rest of the World' compared to the US, leading to a fall in demand for the Dollar and relative weakness for USD versus RoW counterparts.

However, Q1's slowdown in the UK and Europe, combined with trade war fears hitting emerging market currencies and a general inertia in RoW central bank intentions to raise interest rates has helped the US stand out as somewhere where interest rates are still rising, and rising at a relatively brisk pace.

Higher interest rates tend to support a currency as they attract greater inflows of foreign capital drawn by the promise of higher returns, so this has contributed to the strengthening of USD which has broken some key levels against both the Euro and Pound.

"We retain a broadly constructive view of the USD vs. a range of currencies including the EUR and the Pound," says Foley.

As for Sterling, the outlook is, conversely, much less rosy, according to Rabobank. The main factors contributing to the more depressing outlook are economic and political in nature.

Starting with the political, the two main problems are the fragility of the May administration and the intractability of the Irish border question in Brexit negotiations.

The Irish border issue is seen to be the main problem for negotiations, and by extension Sterling, as it has the potential to derail the Brexit process completely and lead, in a worst-case scenario, to the UK crashing out of the EU in March 2019, with no deal and without a transition agreement extension.

We have noted here that the question of the border remains a key risk to the Pound that markets might be guilty of underpricing.

Whilst a tacit agreement has been made to extend Brexit until December 2020, this has yet to be formerly ratified with all the attendent risks that it may not.

The expectation of a transition period had helped the Pound rally up to 1.1599 April highs from the 1.11 March lows, but the new paradigm for Brexit negotiations now appears to be that 'nothing is agreed until everything is agreed' and most importantly until Ireland is agreed.

Ireland poses a potentially intractable problem. Both the main solutions have major drawbacks and cross UK government 'red-lines' of negotiation in some way.

The first option is that of the UK remains in the customs union, keeping the border open. This has the advantage of leaving the border unchanged but the disadvantage of keeping the UK in the customs union and therefore unable to make its own trade deals with third parties.

The second option is that Northern and Northern Ireland have an 'intelligent border' which uses light-touch, high-tech surveillance equipment and a system of pre-approval and trusted-traders to speed up border checks.

The problem with this option is that it would change the border and make it less 'open' - the advantage is it would allow the UK to exit the customs union.  

An offshoot of the intelligent border option is government's latest solution of a 'customs partnership' which involves customs harmonisation. It would see the UK mirroring the EU's customs rules at its borders and collecting tariffs on behalf of Brussels.   

Forecasts: Pound Sterling Lower Now, Higher Later

Rabobank thinks that regardless of which option eventually wins out "the bones of an of a UK/EU free trade agreement will be on the table before the start of Brexit in March 2019."

And for this reason, they have a constructive longer-term 12-month view of the Pound.

Although both sides want clarity earlier - by October preferably, when the EU votes on the transition deal and broader withdrawal bill - they may not get it and for that reason, Rabobank's Foley is bearish about the prospects of the Pound in 2018.
 
The final depressing factor for the Pound, however, is economic in nature. The UK's poor Q1 GDP result of only 0.1% contrasted negatively with the US (2.3% annualized) and Eurozone (0.4%). It further kicked the can of raising interest rates down the road as the Bank of England is now not expected to hike rates at its May meeting. The US Federal Reserve, in contrast, is expected to raise rates soon, and continue raising them fairly regularly. The end result is weakness for the Pound versus the Dollar.

"The acknowledgment from BoE Governor Carney in mid-April that “we have had some mixed data” and that he is “conscious that there are other meetings over the course of the year” severely dampened expectations for a May rate hike. These took another lunge lower last week on the release of the dismal UK Q1 GDP release showing a dismal 0.1% q/q rise," says Foley.

The analysis overall leads Rabobank's Foley to forecast the Pound-to-Dollar exchange rate falling to a bottom of 1.34 in the short to medium term before rising again as a firmer Brexit deal takes shape in early 2019.

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