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2018 is unlikely to be the year of palpable relief for Sterling, argue economists at German investment bank Joh. Berenberg, Gossler & Co, who have found the Pound to be undervalued by as much as ten percent on a trade weighted basis.
Typically, a currency undervalued by such a margin will inevitably recover; but the timing of a recovery is hard to call and it appears the Pound Sterling might suffer undervaluation for years.
Indeed, the findings from Berenberg come as the Pound struggles to extend its late-2017 rally against both the Dollar and Euro. It is currently in the passenger seat against both these currencies.
The Pound-to-Euro exchange rate has fallen below 1.13 once more as the Euro catches a strong bid ahead of the weekend, courtesy of some more-hawkish-than-expected minutes from the European Central Bank. The Pound-to-Dollar exchange rate, meanwhile, remains below January's highs at 1.3550 amidst a broad-based recovery in the Dollar.
And, if Berenberg are correct, this state of affairs, in which Sterling is unable to take the initiative, could last throughout the coming months as Brexit negotiations keep traders on the sidelines.
Analysts at the investment bank warn that, even after assuming the UK avoids a “no deal” Brexit, Sterling will still remain substantially below its pre-referendum level against the Euro and US Dollar by the time the end of 2019 comes around.
“As the Brexit polls began to narrow, markets began to seriously price in the prospect of the UK leaving the EU. Sterling depreciated in the run up to the Brexit vote, despite the continued economic expansion. When the UK voted for Brexit on 23 June 2016, Sterling took another big leg down,” says Kallum Pickering, a senior UK economist at Berenberg.
Between its peak in December 2015 and trough in October 2016, the trade weighted Sterling declined by a total of 22%. Today it is around 13% below its long term average.
“Sterling was strong on a real trade-weighted basis during the pre-Lehman upswing, before declining with the economy during the financial crisis. Although this gap widened after 2009 – partly due to the BoE’s easing monetary policy keeping Sterling undervalued – the Pound had appreciated until 2016 as the economy recovered,” says Pickering.
Economic Growth Suggests the Pound Should be Higher
The fall is unusual because the British currency has historically tracked the path of the UK economy, which has held up relatively well since the Brexit vote in June 2016.
“Despite continued resilient growth, the hard Brexit risk has weighed on the Pound, which remains at the low levels seen during the financial crisis versus its major pairs, the Euro and the Dollar,” Pickering notes.
Britain is still well within the two year Article 50 period and negotiations over Brexit are ongoing. The economist and his team say the current low level of the Pound reflects a host of potential outcomes from the talks that range from no Brexit at all to a “hard no deal” Brexit.
There is around a 45% chance of a “semi-soft Brexit” where the UK remains subject to some EU rules for some goods and services to avoid a hard border in Ireland, according to Berenberg, something that would get the backing of both sides of the parliamentary Brexit divide.
Remain supporting MPs could support the deal because it keeps the UK close to the EU while Brexit backing MPs might support it if the UK is free enough to pursue its own ambitions on foreign trade, Pickering says.
Forecasts for the Pound
If the Berenberg assessment is right then there is only a 5% chance of no Brexit taking place at all and around a 20% chance of the UK leaving the EU without any deal at all and defaulting to trading with it on World Trade Organization terms.
This would be the most disruptive outcome as it would reduce the UK’s trend economic growth rate from its pr-Brexit level of just above 2% before Brexit to around 1.5% after a disorderly Brexit.
“As long as there is a risk of a hard Brexit – we see a 20% chance – markets will remain reluctant to act on the continued resilient short-run economic data,” says Pickering.
“After all, who knows what the economy will look like in 18 months’ time if the UK crashes out of the EU without a trade deal?”
“In the long run, with potential growth of between 1.5% and 1.7% (our Brexit base case) Sterling is probably undervalued on real trade-weighted basis by between 5% and 10%,” Pickering concludes.
Berenberg forecasts that the Pound-to-Euro rate will only make as far as 1.1600 between now and the end of 2019, while the Pound-to-Dollar rate is seen rising only as far as 1.43. Both of these predictions assume the UK avoids a hard Brexit.
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