Keep Selling British Pound Against the Euro: JP Morgan

The Pound to Euro exchange rate remains overvalued argue JP Morgan who believe a second bout of post-referendum weakness is about to be triggered by the Bank of England.

The UK currency has bounced off the key support level at 1.18 against the Euro in a move that confirms markets have turned increasingly nervous of the Bank of England's Thursday policy event.

We have noted that there remains a chance that the currency pair could in fact target 1.20 on the basis of the short-covering rally seen heading into the BoE event.

With uncertainty rife as to just how agressive the Bank intends to be, it is understandable that traders would rather sit this one out.

Exiting the market necessarily requires traders to purchase Sterling in order to cover their negative bets.

The recent strenght in Sterling could therefore be technical in nature.

Indeed, the fundamentals behind the UK unit remain negative argue JP Morgan, who, as we reported last week, are forecasting the Pound to fall to 1.12 against the Euro in a 'second wave' of devaluation of the British Pound being sparked by the Bank of England.

With changes nigh, JP Morgan have doubled-down on their call and this week recommend that those who are not already betting against Sterling should do so, via a 1 month call spread.

The strategy implies downside risks for the Pound to Euro exchange rate (GBP/EUR) which is quoted at 1.1887 on the mid-markets at the time of writing.

Not Enough Recession Priced Into the Pound

The recommendation is an interesting one as we note growing dangers inherent in the stance as there is the prospect that the Bank could underwhelm market expectations and not deliver an aggressive policy stance.

Nevertheless, JP Morgan’s Meera Chandan says clients should stay bearish GBP and initiate a short vs the Euro.

“We have been recommending GBP shorts motivated by the view that there is not enough recession priced into the currency. This concession continued to compress this week as illustrated by GBP/USD which strengthened modestly even though UK-US yield spreads declined further,” says Chandan.

The short GBP stance remains a high conviction view, GBP valuations aside, economic momentum in the UK has slowed by more than expected argues Chandan.

The analysts cites a slew of negative data points that have been released since the referendum:

• Composite PMI released on 22 July (Add to this the August 1st Manufacturing PMI release)
• the CBI Business Optimism index making new 7-year lows
• GfK consumer confidence registering larger declines than the advance estimate to -12 (JPM’s economists note that -15 is consistent with recession).

Given the recent data, analyst expect the BoE to ease aggressively in the Quarterly Inflation Report out on Thursday.

A preference for aggressive action is predicated on the observation that some well-known hawks, such as Martin Weale, have indicated the need for policy easing given weak data (recall that earlier he had recommended waiting for firmer evidence before making a policy change).

JP Morgan’s base case is for a 50bp rate cut with QE of £75bn.

For GBP, rate cuts will matter more than QE.

“In this regard, the important issues will be the magnitude of rate cuts delivered (as a rule of thumb, every 10bp weakens the currency by 1%) and any forward guidance from the BoE on it’s preferred channel for further monetary policy easing (a preference for QE over rate cuts will limit how much GBP can weaken),” says Chandan.

Latest Pound/Euro Exchange Rates

	Live: 1.145▲ + 0.06% 12 Month Best: 1.2162
*Your Bank's Retail Rate	1.1061 - 1.1107
**Independent Specialist	1.129 - 1.1336 Find out why this is a better rate

* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

JP Morgan’s bearish view on GBP is predicated not just on lack of concession in the currency, but also on the view that not enough is priced into UK rate markets.

Only 25bp rate cut is priced by markets for August and an additional 10bp of rate cuts are priced in for the next year.

“We recommend initiating shorts in GBP vs. EUR this week,” says Chandan.

Risks to the Trade No. 1: A Short-Squeeze Higher on BoE Disappointment

The risks, in our view to chasing the Pound lower against the Euro, are headed by a Bank of England that takes a sanguine approach to fresh policy measures on Thursday.

Added to this is the fact that the short-GBP trade could become overcrowded.

A market needs fresh entrants to jump into a trade if it is to evolve in a given direction.

If everyone and his dog are betting the same way there is the risk that momentum fades as the market is all-in.

"The risk to the view are GBP shorts which appear crowded," says Chandan, "this should limit how much GBP can weaken."

Risks to the Trade No. 2: A Stabilisation in Economic Activity

We would also suggest there are risks to the view that "not enough recession is priced into the currency."

Analysts have cited the worst of the readings and could be accused of ignoring the more positive data points that have come out of late.

For instance, The Lloyds Bank Business Barometer showed business confidence had risen 23 points in July, while a similar finding from the ICAEW showed that their Index fell drastically after the EU Referendum but confidence has crept up since that point as businesses take stock.

Data released on Tuesday the 2nd of July showed that the construction sector remains in contractionary territory with firms continuing to show indecision on future investments.

However, the takeaway from the Construction PMI report from IHS Markit is that there is evidence sentiment is starting to stabilise.

This is supported by the earnings reports from some UK homebuilders, who haven’t seemed to materially changed their outlooks in the wake of Brexit.

“Hope of further stabilisation has come with the newly appointed government, with the new Prime Minister and Chancellor Philip Hammond strongly indicating that they will continue to invest in major infrastructure projects to support the economy," says Mark Ronins, the Chief Executive at Scape Group.

Simply put, we need more data.

Of course the whole point of forecasting is to put your neck out and make the call, and it would seem like JP Morgan are confident in theirs.

UK Services PMI Stabilise Sentiment

The UK faces a mild-recession, based on the evidence provided by the much-anticipated Services PMI reading for July.

The data reflects business sentiment in the month following the Brexit vote, a time when the shock of the outcome was expected to be at its worst.

While there is talk of recession, we find it encouraging that the data released on third August shows no deterioration on the flash results released at the end of July.

Markit/CIPS finalised the preliminary July PMI data, leaving the services reading unchanged at 47.4 and nudging the composite reading slightly lower to 47.5 (47.7).

Markets are looking for easing measures from the BoE tomorrow but there is some debate about how aggressive the BoE will be.

Scotiabank analyst Shaun Osborne says he looks for a 25bps cut in the bank’s key rate (to 0.25%) and for an additional GBP50 bn in QE.

There is a consensus on the rate cut, less so on the asset purchase issue.

"Recall that CFTC data Friday showed record speculative net GBP shorts, suggesting ample room for a squeeze on positioning in the event of the BoE disappointing expectations," says Osborne.

Therefore, risks are evenly balanced to the upside and downside it would appear.