UK economic growth in 2018 is tipped to slow at a faster rate than economists and policy makers at the Bank of England expect; and this surprise will have material implications for the value of Pound Sterling.
New research from BNP Paribas - France’s second largest bank - has confirmed to clients that they see the value of Pound Sterling declining to a low which will be reached in the first-half of 2018 as UK economic growth underwhelms against current expectations.
"We expect growth in the UK to slow materially more than the Bank of England projects. It forecasts 1.6% growth for 2018, we expect growth to slow to 1.0%," says BNP Paribas FX Strategist Sam Lynton-Brown.
The Pound fell in response to the event after the Bank’s Monetary Policy Committee
removed the line that rates may need to rise by more than the market is pricing in and reiterated any further tightening would be limited and gradual.
“The BoE itself is basing its economic forecasts on an assumption of two further rate hikes over the next three years, which is an extremely gradual path for rates,” says Lynton-Brown.
The Pound has since recovered some lost ground against both the Euro and US Dollar suggesting that the market agrees that two further interest rate rises are indeed likely - it is this assumption that two more interest rate rises are coming that is keeping Sterling supported.
Lose this assumption, and the Pound will likely fall.
Indeed, BNP Paribas reckon the Bank of England's growth forecasts will prove too optimistic and interest rates will likely be retained at current levels for an extended period of time, as lower interest rates make borrowing more affordable and keep the interest repayments on loans manageable.
Interest rates, and interest rate expectations, have a significant impact on currencies as higher interest rates attract more inflows of foreign capital as global investors are drawn to the promise of higher returns.
Increased inflows mean greater demand for the currency, thus raising its value.
As the probability of another rate rise dwindles due to poor growth, as in the BNP Paribas scenario, the Pound will therefore probably fall.
BNP Baribas’ economists expect growth in the UK to slow materially more than the BoE projects. “We expect growth to slow to 1%. As growth slows, we anticipate that the pricing which remains in the market for further BoE rate hikes will be unwound and in sympathy GBP should continue to weaken,” says Lynton-Brown.
“Evidence that the economy is slowing more than the BoE expects would be a catalyst for further GBP weakness,” says Lynton-Brown. "We, therefore, maintain our bearish GBPUSD view, targeting a move to 1.25 over the next 6 months," says the strategist.”
Above: Adding to the bearish setup on Sterling is positioning which shows investors have room to enter substantial bets against the Pound.
BNP Paribas' GBP Forecasts
The Pound is expected to weaken into 2018 but we note the low-point for the currency is seen around the end of the first quarter 2018.
The Pound-to-dollar exchange rate is forecast to trade at 1.26 by year-end, 1.25 by the of March 2018, 1.29 by end of June 2018 and 1.40 by end-2018.
The Pound-to-Euro exchange rate is forecast to trade at 1.10 by end-2017, 1.09 by March 2018, 1.11 by mid-2017 and 1.14 by end-2018.
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Or will the Pound be Heading in the Opposite Direction?
BNP Paribas are clearly bearish on Sterling over the medium-term, but readers of Pound Sterling Live will be aware that there are optimistic viewpoints regarding the Pound’s outlook to consider.
And of course, the discussion on Sterling’s future rests not just with the Bank of England, but with the progress of Brexit negotiations.
There already appears a much greater chance of a transition period before Brexit-proper, which will give negotiators more time to renegotiate a new trade relationship and avoid a cliff-edge to WTO tariffs.
Such an outcome would likely protect the economy from a brexit shock and keep growth rates relatively robust, indeed analysts at Capital Economics expect the UK economy to remain surprisingly resilient.
“We continue to think that the markets are underestimating how quickly rates will rise in the UK," says John Higgins, chief markets economist at Capital Economics. “As the economy weathers the uncertainty over Brexit well.”
Rather than expecting the BoE to backtrack on its two expected rate hikes in 2018 and 2019, Higgins actually sees the BoE raising rates much more than it currently projects, with three hikes in 2018 alone, taking the interest rates to 1.25%.
“Only one further 25bp increase is discounted in the overnight indexed swap (OIS) market between now and the end of 2018, whereas we anticipate that there will be three – taking Bank Rate to 1.25%,” says Higgins.
Such a steep upwards trajectory for interest rates is likely to result in a rise in Sterling exchange rates.
Higgins thinks the Pound will rise the most against the Euro, against which he forecasts to rise to 1.23 by the end of 2018 whilst the Pound will only rise to 1.35 with upside in GBP/USD being capped by a robust Dollar.