Currency Focus: Bad Moon Rising for the (UK and the) Pound

By Shant Movsesian and Rajan Dhall MSTA

Excuse the use of a great song by the Creedence Clearwater Revival, but this pretty much sums up how we see the next few months developing for Sterling, as the ramifications of the vote to leave the EU continue to filter though to the real economy.  Stepping aside the issue of whether is was right or wrong for the UK to vote to leave, the harsh reality is that there will be a disruptive impact on the UK, but in getting past the initial shock and surprise of the referendum result, the last 6 months or so have seen the market tagging onto what has been the ‘revaluation trade’, pricing out the Brexit discount, whilst also factoring in expectations of a rate hike on the horizon, perhaps as early as May.

On the Brexit talks alone, it will not have gone unnoticed that the Pound has been enjoying a purple patch while there has been a recess in the negotiations, but now that the talks are set to get under way again, the recent to and fro of exchanges regarding the draft proposals from each side have been garnering greater interest given neither side is happy with the the demands of the other.  Financial services is a major bone of contention, and we are already seeing a number of banks starting to relocate staff to some degree (contingency plans warrant some early displacement), and the effects of this will felt going forward as operations such as EURO swaps clearing are prime for an eventual move.   The EU are adamant that finance will not be part of the main trade deal, with single market access in this area set to be limited at best.  

Many are also very sceptical on how the UK government can insist on no hard border between Northern Ireland and Ireland without exiting the Customs Union.  The DUP are quick to the stamp their foot down on creating a sea border, as was alluded to in the EU’s draft proposals.  In an interview on Sunday morning, the UK chancellor Hammond suggested the current excise laws could accommodate this through security and policing, but this has no precedent and requires all EU 24 member states to agree to this which may cause internal divisions.  Citizens rights are also a sticking point, more so during the transition period and all of this reverts us to the argument above, that the uncertainty discount in Sterling is generous at this point. 

On the economy, there are a number of factors which will be problematic, and the contribution to the Treasury from the financial services sector needs no elaboration given what we have covered above.  Manufacturing and production numbers last week revealed that exchange rate advantage is also fading, but put in context, is still only around 20% of the UK’s GDP.  Where we see the greatest risk going forward is in consumer spending, and a key factor in this will be the state of the housing market which his coming off the boil.  Over the last 20 years, we have seen strong gains in house prices here in the UK, and with the concurrent rise in credit and credit creation, spending has been a huge component in the economic prosperity (in absolute and relative terms) over the period.  Growth projections over the next couple of years have already been downgraded due to Brexit related hesitation in business investment, so this is an area which has a high probability of adding to the pain.  Last week we saw the RICS survey showing the price balance falling from 7 to  0 in Feb, having eased off from 8 in the previous month.  High street spending will develop into a major concern if house prices continue to adjust, with the disparity in wages and affordability already at hugely stretched levels.

Based on a combination of the above, are we about to see the BoE continue with their tightening bias, which in fairness, is predicated on a transition deal being agreed.  This is may be seen as an ambitious hope given EU negotiators have insisted that this will be agreed on along with the ultimate trade deal, but whilst sounding a touch cynical,  does offer the MPC a get out clause if data and events conspire against them.

Even though GBP has come off better levels against the USD, EUR and JPY, we have continued to see the strength maintained against commodity currencies.  With trade heavily weighted to Europe, EUR/GBP is in focus and this is where we see some upside risks fermenting going forward.  If the USD manages to correct a little further as looks to be developing, there is a strong case for GBP/USD to head back through the 1.3600-1.3500 area, which provided strong resistance on the way up.  We would expect to see a move down to towards 1.3000 at some point later in the year, if our assertions gather momentum, but we certainly see little reason to reassert the more ‘optimistic’ narratives which suggest Cable back to 1.4500-1.5000 and EUR/GBP to sub 0.8500.  We are inclined to see 1.3600 tested over the next week (or two)  with or without an impending move in EUR/GBP through 0.9000, however if risk sentiment can hold up as seems to be the case with president Trump watering down his proposals on tariffs and talks with North Korea on the cards,  AUD, NXD and CAD all offer even more attractive levels from which to differentiate against GBP.