MUFG Confirm they see the Pound Higher in 2018 on "Smooth and Orderly" Brexit

Barnier and Brexit negotiations in 2018

Above: Michel Barnier, Chief Negotiator in charge of the Preparation and Conduct of the Negotiations with the United Kingdom © European Union, 2018 / Source: EC - Audiovisual Service / Photo: Mauro Bottaro.

The British Pound could be one of the best-performing currencies in 2018 argue analysts at a leading international financial services provider.

MUFG - the Japan-based global financial services giant - are anticipating Pound Sterling to continue 2017's rally and outperform rivals in 2018.

"The Pound’s ongoing resilience continues to support our view from over a year ago that a lot of bad news was already priced in," says Derek Halpenny, European Head of Global Markets Research who is based at MUFG's London office.

Pound Sterling was one of the best performing G10 currencies in 2017 as it successfully "climbed a wall of worries" concerning the U.K. economy's ability to withstand concerns surrounding Brexit.

However, "an important positive implication for the Pound is that the risk of a more disorderly 'No Deal' Brexit outcome has diminished and the pound should strengthen if fears over a more disruptive and harder Brexit outcome do not materialise," says Halpenny.

A central concern for analysts is that the U.K. exit the European Union without a trade deal and formal relationship in March 2019, a scenario that is assumed will create significant uncertainty and hamper U.K. businesses. But signs of progress in Brexit negotiations has provided some confidence that the Government does have the ability to negotiate a best-possible outcome for the U.K. under the circumstances.

November 2017 saw Sterling rally as Theresa May secured a deal with Brussels covering the 'divorce' conditions between the E.U. and U.K. - these included issues surrounding the financial settlement, the Irish border and the future status of each sides' citizens living either side of the channel.

The Pound's positive response to progress confirms Sterling to ultimately be a 'political currency' and places Brexit firmly in the driving seat when it comes to future moves.

"The Brexit issue is set to remain the main driver for GBP in 2018 and while uncertainty and fundamentals justify an undervalued GBP for now, we see prospects of a recovery in 2018 as clarification on Brexit increases," says a strategy note from Danske Bank where analysts are betting the Pound will recover against the Euro in 2018.

All eyes now turn to the issue of the transitional period that will govern the releationship between Europe and the United Kingdom in the two years following Brexit with the E.U.'s chief negotiator Michel Barnier saying the issue will form the focus of the next stage of discussions.

Bank of England in Play

But MUFG believe for Sterling, 2018 is more than just politics and the economy could also prove supportive.

U.K. economic growth decelerated in 2017 after being the developed world's fastest growing economy in 2016 and many saw this slowdown as reason to adopt a cautious approach on Sterling. Annual real GDP has slowed - but by a
smaller degree than expected - from 2.0% at the end of last year to 1.7% as of Q3.

"As expected, the depreciation of the Pound post-referendum resulted in higher inflation last year and a squeeze on real incomes, which slowed consumer spending," notes Hardman. However, the analyst expects that negative element to subside as a factor slowing growth this year with evidence that the growth in nominal wages is picking up while evidence
also points to inflation related to Pound depreciation easing.

MUFG note nominal earnings growth on a 6mth annualised basis has been running at stronger levels than the annual rate while the UK living wage is set to increase by 4.4% from April suggesting better nominal wage growth levels this year.

"Hence, we suspect the building evidence that the squeeze on real wages may now be subsiding will prompt the BoE to become more optimistic on the outlook for economic growth," says Hardman.

While the real wage squeeze may subside, MUFG believe the threat of domestically driven inflationary pressures will ensure that the MPC will remain alert to the threat of inflation.

The U.K. economy continues to see unemployment decline, which when combined with slowing immigration levels puts constraints on the labour force. Wages are therefore likely to move higher in response as employers increase their bids for scarce labour.

Higher wages tend to lead to higher levels of inflation and this could prompt the Bank of England to react by raising interest rates.

"This will result in the forward guidance of the MPC changing, perhaps at the February MPC meeting with the signal then guiding the market to two rate increases this year. We expect the next MPC rate increase in May," says Hardman.

The Pound rose in anticipation of 2017's single interest rate as confirmation of a positive correlation between higher U.K. interest rates and a stronger Pound.

The promise of further rate rises in 2018 should see the Pound move higher still.

Forecasts for the Pound

MUFG forecast the Pound to buy 1.4250 US Dollars by mid-2018, with purchasing power increasing to 1.4680 by year-end.

The Pound is forecast to buy 1.1494 Euros by mid-2018 with the exchange rate rising to 1.1560 by year-end.

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