GBP: Rocky road ahead - Rabobank

Measured from its April high, cable is currently trading around 4.5% weaker and this move is partly a reflection of the better tone of the USD, but it is also a function of the plunge in market expectations regarding the prospects of a BoE rate hike next week, according to Jane Foley, Senior FX Strategist at Rabobank.

Key Quotes

“Having traded sideways between late-January and mid-April, the USD’s performance has recently taken a turn for the better. The DXY dollar index has today broken above the 200 day simple moving average and in recent sessions the dollar has broken a number of key technical levels vs. the EUR and many EM currencies.”

“Although the USD has largely ignored the draw of interest rate differentials since the start of last year, we expect that higher rate spreads will sooner or later lend the greenback support.  We retain a broadly constructive view of the USD vs. a range of currencies including the EUR and the pound.”

“The domestic influences on GBP can be split between economics and politics. In turn the latter can be divided between risks linked with a breakdown of the current government and Brexit.  The agreements in December and March on the legacy issues connected with Brexit and on the Transition period respectively were taken by the market as reducing the chances of the UK leaving the EU without a trade deal; though this is still possible.  These agreements were therefore sterling supportive.  That said, both these deals glossed over the issue of how to avoid a hard border on the island of Ireland and PM May is increasingly being pressured to come up with an acceptable solution.   UK Brexit Minister Davis has indicated that he wants to move quickly when Brexit talks restart tomorrow and May’s team has reportedly drafted another proposal as to how the UK can exit the single market and customs union and simultaneously avoid a hard border.”

“The lack of an acceptable solution on the Irish border puzzle has recently been supporting speculation that the chances of the UK remaining within the customs union post Brexit have risen. While this would remove some of the Brexit connected uncertainty, it is difficult to argue that this outcome would be supportive for GBP since such a scenario would reduce the credibility of the PM and could mark the end of her government.  It remains our house view that the bones of a UK/EU free trade agreement will be on the table before the start of Brexit in March 2019.  For this reason we are forecasting a stronger pound on a 12 mth view.”

“Indeed, both sides want a deal by October to allow all EU national parliaments time to ratify the agreement. That said, this is a very short timeframe to hammer out an agreement on trade and we expect political uncertainty to pressure the pound during much of the reminder of 2018.”

“In recent weeks it has been economic data and the BoE rather than politics that have been providing a greater degree of direction for the pound. In February, the BoE delivered strong guidance that further policy tightening was on the cards and the market duly prepared for a rate hike in May. Strong economic data, however, has not been forthcoming.  The acknowledgement from BoE Governor Carney in mid-April that “we have had some mixed data” and that he is “conscience 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.  Given our constructive view on the USD, see risk that GBP/USD could trade as low as 1.34 before the end of this year before rallying on the assumption that the EU/UK agree on a trade deal.”