Pound to Decline against Euro in 2023: RBC Capital's Thematic Trade of the Year

Pound and Euro

Image © Adobe Images

Foreign exchange strategists at RBC Capital say the Euro will likely rise against the British Pound in 2023 owing to their pessimistic view on the UK economic outlook.

Being 'long' EUR/GBP forms one of RBC Capital's thematic trades for the coming year as analysts expect further weakness in the Pound amidst a chronic UK economic underperformance, persistent twin deficits and improved demand for Eurozone assets.

"September's 'fiscal event' may have brought the UK imbalances into sharp focus, but they were there before the short-lived policy changes at that time," says Elsa Lignos, Global Head of FX Strategy at RBC Capital Markets.

These imbalances are:

1) Budget deficit. The UK maintains a long-running budget deficit as the government continues to spend more than it earns in taxes. The OBR forecasted in November that the UK's debt burden would rise to a peak of 99% of GDP over the next three years.

Debt is forecast by the OBR to be roughly £400BN higher than had been forecast in March, and interest costs accrued to service these debts would be close to historic highs.

2) Current account deficit. The UK's current account remains in deficit as the UK imports more than it exports, meaning it buys more foreign exchange than it earns.

The ONS said the underlying UK current account deficit - excluding precious metals - reduced to £32.5BN, or 5.3 % of GDP, in the second quarter of 2022, a change of £4.4BN from the previous quarter.

The UK current account deficit - with the trade in precious metals included - reduced to £33.8BN, or 5.5% of GDP in the second quarter.

Despite the foreign exchange outflows implied by a current account deficit, the Pound can stay steady or even appreciate if foreign investors buy UK assets, and/or if UK investors repatriate earnings on foreign investments.

This dynamic leaves the Pound vulnerable to moments when foreign investor flows dry up, as is typically the case during global market declines.

"They are still there now, with budget and current account deficits running at 6%+ of GDP and the need to keep drawing in foreign capital making a strong case for grinding GBP losses," says Lignos.

UK's twin deficits

Other reasons to expect a fall in the value of the Pound to Euro exchange rate include Sterling's apparent overvaluation, even after 2022's losses. (They arrive at this overvaluation on relative labour costs).

RBC Capital also say the economy is in a "cyclically poor position," with most economists in agreement it has already fallen into recession.

Further downside for the Pound might arise if the Bank of England delivers significantly less tightening than the market is currently anticipating.

"The case for remaining negative on GBP is strong," says Lignos. (If you are looking to protect or boost your international payment budget you could consider securing today's rate for use in the future, or set an order for your ideal rate when it is achieved, more information can be found here.)

The Euro is meanwhile seen as better supported against the Pound as long-term capital flows are expected to be potentially supportive of the Euro, with European investors expected to reduce their structurally overweight position in U.S. equities.

"Many of the cyclical negatives (energy prices and squeezed real incomes in particular) are common to the Eurozone and the UK and EUR/GBP should therefore be less exposed if these factors turn less negative in 2023," adds Lignos.

RBC Capital also bet against the Pound in 2022, but the currency at the other end of the trade was the Canadian Dollar.

The GBP/CAD exchange rate is down 3.7% in 2022, having started the year at 1.7104 and quoting at 1.6463 a the time of writing.

However, at one point the exchange rate went as low as 1.4064, giving a peak-to-trough performance of 19%.

"In pure G10 trades, the best performer was short GBP/CAD and we still like the short GBP leg of this trade," says Lignos. "All but one of our longer-term thematic trades for the year delivered positive returns and again for the aggregate of all trades, it was a record year."