Pound to Dollar Rate Forecast to Retreat to 1.35 on UK Yield Warning Signals

UK gilt yields and the pound sterling to start falling on Bank of England

'Bremain' odds are unlikely to advance much further argue TD Securities who warn this could be as good as it gets for the pound and interest rate yields.

The yield on UK sovereign debt has rallied sharply as investors demand less return for holding UK assets ahead of the EU referendum.

The move higher has been sharp and fast, with the Dec 16/Dec 17 short sterling spread reaching a low of 8bps two and a half weeks back, to now over 3 times higher at 26bps.

“A fall in Brexit premia and assurance from the BoE that they will remain less sensitive to data ahead of the June referendum, have come together to support UK yields higher,” says Renuka Fernandez at TD Securities in London.

The rise in UK yields betrays an increase in demand for UK assets, which in turn explains why the British pound has also moved higher of late - the buying of UK debt requires the buying of sterling.

The question of where sterling’s limit against the euro and dollar is to be found is one that has preoccupied our work over recent days, and indeed, there are signs that we are starting to see sterling top out

Looking ahead, Fernandez and her team’s believe that UK yields have reached their upper limit and this should serve as a hint that the British pound’s rally is increasingly at risk of failing.

“We see growing risks of a pull back in pricing with several key central banks looking increasingly dovish and with betting odds now likely as high as they are going to get in the run up to the EU Referendum,” says Fernandez in what is clearly a warning to those thinking of sitting back and waiting for a stronger British pound.

Bremain Odds: As Good as it Gets

The implied probability of a vote for “Bremain” has risen several percentage points to about 75%, according to bookmaker Betfair.

Ladbrokes' indicates a 73% chance of Britain voting to remain post-Obama and William Hill sees "Brexit at longest odds yet of 13/5" and Remain at 2/7.

However, this is as good as it gets suggests Fernandez:

“The fall in Brexit premia is also likely overdone in our view. The current odds are 75% for Remain, however the referendum is two months away - as such we see risks that these odds fall as we draw closer to the Referendum date - again pressuring yields lower.”

The Bank of England is also critical in supporting higher UK yields via raising their base interest rate.

Sterling has fallen over recent months alongside expectations that the first interest rate rise could happen as far back as 2020.

Over recent days bets on an earlier rate rise have been growing.

However, those betting on an earlier rate rise could be at risk of getting ahead of themselves, particularly if the US Federal Reserve stalls on raising rates.

“Even if Brexit does not materialise—it is now looking increasingly likely that the Fed may only be able to deliver one hike instead of two this year—making a hike this year from the BoE less likely, as well,” says Fernandez.

Fernandez’s views are however at odds with those of her colleague, James Rossiter, who reckons there is in fact a chance of a 2016 rate hike at the Bank of England.

Rossiter argues that while the MPC has acknowledged that some of this depreciation is linked to the upcoming EU Referendum (and thus sterling could unwind under a Remain win), firms are already facing higher imported costs, and will not absorb this all in their margins, leading to some inflationary pressures over coming months.

If the UK votes to remain in the EU, “we would expect a bounce-back in growth in 2016H2. Thus any uncertainty effects seen (in particular) in 2016Q2 will be unwound quickly,” says Rossiter.

This is forecast to boost growth significantly.

“Once the referendum is out of the way, stronger wages, weaker productivity, imported price pressures, and a bounce in growth should lay the groundwork for a hike in Bank Rate in Nov 2016,” says Rossiter.

Given, Rossiter made his views on the Bank of England known in mid-April, and they may too have turned more bearish but in a note to clients on Wednesday the 27th he too cofirms gilts - and the pound to dollar exchange rate - are to fal:

"The rise in betting odds led us to take profit on our Dec16/Dec17 short sterling steepener trade today, but on the FX side we maintain our view that GBPUSD will continue to depreciate into the vote date, with a target of 1.35."

The technical setup behind sterling does however remain positive, therefore while we stop short of suggesting the rally is over, we suggest those with an interest in the market keep cogniscent of developments in the rates market.