Two prominent financial market sages have forecast the GBP / USD exchange rate is at risk of a fall to parity, however most analysts appear content to call the bottom at 1.20.
The British Pound managed to end the final day of the week gone by higher than where it closed.
GBP/USD opened its account at 1.2885 and closed at 1.2957 with markets showing their disappointment to the latest set of employment data from the US.
The latest Employment Situation report from the Bureau of Labor Statistics showed job growth rebounded strongly by 287K in the month of June, ahead of a market forecast for 175K.
The unemployment rate rose more than expected but average hourly earnings growth slowed.
Job growth was incredibly weak in May but instead of an upward revision, the report was revised down by another 27k.
This leaves the 2-month average at less than 150k which is arguably a soft number for the US Federal Reserve to justify a September interest rate rise on.
Without the prospect of future interest rate risese the broader Dollar complex could struggle to establish meaningful momentum higher, something that could provide a heavily oversold GBP/USD with some respite.
Forecasts Confirm More British Pound Downside
With the implications of the UK’s Brexit vote begin to sink in, research analysts see protracted downside risks for sterling.
A good majority of those analysts we follow now expect GBP/USD to trade down to 1.20 by the start of 2017.
However, the balance of risks to these forecast are currently skewed to a larger decline.
Key to the depreciation will be the Bank of England which is expected to cut interest rates lower, to perhaps 0%.
All the while expectations for another interest rate rise in the United States in 2016 keep the USD buoyed.
George Magnus, the independent economist and commentator who was Chief Economist at UBS from 1995-2012, says that the prospect of GBP/USD falling to parity is real.
“I said before the referendum it would most likely fall by 20 per cent, and that still looks likely. If the economy really shuddered, parity is quite possible,” says Magnus.
The big variable to note is “if the economy really shuddered”.
What such a shudder looks like is unclear.
“I personally expect a recession to take hold, starting with a slowdown in the third quarter. Lending and spending decisions, especially when it comes to house purchases and investment, normally go on hold under conditions of uncertainty, of which we have more than enough,” says Magnus.
Magnus is not alone in his expectations for recession, as we have noted recently, a good number of institutional economists are also warning of recession.
“It matters, of course, whether we do experience a recession, not least to those who will lose their jobs, or have to weather wage stickiness. But it will also matter a lot to the Government’s fiscal position which would deteriorate sharply,” says Magnus.
For export-oriented companies, the fall in the Pound is a mitigating factor in the outlook.
Standard economic thinking suggests that the fall in the pound will stimulate UK industry via the export channel.
A fall of 10% in the Pound trade weighted index would suggest that UK goods and services just got 10% cheaper on the international market place.
This should stimulate bargain hunting.
“There is no question a cheaper Pound will help some companies but it depreciation is most unlikely to offset other economic problems the UK is going to encounter,” argues Magnus.
Magnus cites the following headwinds to UK exports:
- world trade is stagnating and there is no productivity miracle occurring, as there was then with information technology
- China and several major emerging markets have lapsed into a growth hiatus of unknown duration, when in the earlier period they were starting to make their presence felt
- global growth is weak and fragile, whereas it was accelerating quickly 20 years ago
- the UK’s balance of payments deficit is a large 7 per cent of GDP, about 3 times as big as it was before
- the ERM debacle, and lack of confidence in the Pound, could make financing the deficit more troublesome
El-Erian Warns on GBP/USD Parity
Mohamed El-Erian, Economist at Allianz, is also warning that the Pound could reach parity against the US dollar.
In an interview with Reuters the former head of PIMCO said the big cloud hanging over the British pound at present is a leadership void in the UK.
With Cameron gone, and the government seemingly lacking a ‘Plan B’ - otherwise known as a plan for a Brexit vote - investors and businesses are unable to plan for the future.
As noted by Adam Jepsen, writing in Pound Sterling Live, “what is clear is that there's no Plan B for Brexit and there was no Plan A either. The prolonged period of uncertainty just got longer.
“Once the impact of the referendum starts to filter through to more of the UK's economic data it should start to show the gravity of the situation. Market volatility could get worse.”
El-Erian agrees and says the UK has to urgently get its political act together accusing politicians of shirking their economic governance responsibilities.
"Think of Sterling as facing a double whammy with no strong anchor," says El-Erian.
"The future value of sterling is a function of how and how quickly the structural uncertainty is resolved – if Plan B is delayed and/or it doesn't involve much of a free trade set-up with the EU, it is not inconceivable for sterling to head to parity with the U.S. dollar,” says.
El-Erian believes that should timely agreement between the UK and its European partners on a new arrangement that allows for sufficient free trade access, sterling could end up appreciating from its current levels."
“The chatter on forex desks is that the pound could hit parity with the dollar. Although not impossible, this seems a little far-fetched as sterling would have to drop considerably from where it is now," notes Andrew Edwards, CEO of ETX Capital.
Parity would represent an all-time low for the pound.
The consensus forecast amongst surveyed analysts currently stands at 1.20.
Edwards believes much rests with how the Bank of England acts at their July meeting, and argues that doing nothing could actually achieve more than doing something:
"Some are calling for the Bank to hold fire and leave rates as they are – which may be the sensible move. Increasing credit supply doesn’t achieve much if there is no demand and it’s the demand side that matters most.
"A firm vote to hold rates where they are would send a clear signal to investors that the Bank is confident the UK can weather this storm and that it doesn’t want the pound to drop further. Keeping its powder dry would mean it has ammunition for another day, should financial conditions get a lot worse."
What are the chances of an interest rate cut in July, and what are the chances for two interest rate cuts to take place in 2016?
Overnight index swaps are currently implying the following probabilities.
78% chance of a cut next week
86% chance of a cut by August, with a 27% chance rates will be 0% by then
89% chance of a cut by December, with a 34% chance rates will be 0% and an 8% chance rates will be negative by then
So it would appear that one rate cut has been priced into the GBP exchange rate.
The trigger to further downside would be the increased pricing for a second cut.
The other unknown for the currency is whether or not further quantitative easing measures will be announced.
"In our view the market is still likely under-pricing BoE easing, with our economists forecasting a 25bp rate cut next week followed by a 25bp cut at the August meeting and GBP 100bn worth of QE (including corporate bonds) to be announced by the November meeting," say BNP Paribas in a client briefing.
BNP believe lower rates and reduced investment from foreigners should leave the GBP vulnerable for some time to come.
1.00 is too Low, 1.15-1.20 More Likely
The latest GBP/USD update to hit our desk comes from TD Securities and Deutsche Bank have said that parity would likely be a step too far for GBP/USD.
"While GBP has already seen steep declines across the board we think it remains vulnerable to a prolonged decline even from these levels. Our current forecast profile sees GBPUSD falling to 1.20 by the end of this year (1.25 by end-Q3)," says Ned Rumpeltin at TD Securities.
Rumpeltin acknowledges that the current environment lends a greater-than-usual degree of uncertainty about our outlook, but the risks currently appear skewed toward a further—and faster—declines.
Deutsche Bank reiterate their forecasts for a notably lower Pound Sterling against the Euro and Dollar, analyst George Saravelos gives his three reasons:
1) A starting point is purchasing power parity, which measures the exchange rate that equates the price of a “big mac” between two countries.
Our assumption is that the UK is undergoing an unparalleled negative “terms of trade” shock, which requires GBP to reach historical (under)valuation extremes.
2) An alternative metric is the fundamental effective exchange rate.
This measures the exchange rate that is required to bring a country’s current account deficit back in “equilibrium”, which here we define as the 20-year historical average, or in absolute annual terms about -40bn GBP, or 2.5% of GDP.
3) A final metric is to look at the underlying value of assets. What is the level of the exchange rate that would make UK assets “cheap” again and thus keep attracting the capital inflows that are needed to finance the current account deficit?
Here Deutsche Bank looked at the London housing market priced in both dollars and euros as a proxy for “international UK assets” and assume “cheap” would be a return of house prices back to the currency-adjusted levels seen in 2005.
The conclusion from all three frameworks is that GBP has much more to go. Indeed, our aggressive forecasts may still be under-stating the level of weakness required.
Deutsche Bank's forecasts for GBP/USD and EUR/GBP are at 1.15 and 90 pence by the end of this year respectively.
The US Dollar: Payrolls Dominate Near-Term Outlook
Finally, we can focus on something other than Brexit with the release of the US Employment Situation report due out ahead of the weekend.
The minutes of the June FOMC detailed cautious optimism, albeit there was much discussion on the state of the labour market in the wake of the May NFP disappointment.
Of course it can be argued that the minutes are staler than usual as they came ahead of the UK Brexit vote.
But, many analysts hold the view that ramifications of the UK vote will not prove materially significant to US growth expectations we continue the view the strength of the labour market as key to Fed rate assumptions.
Last month’s sharp drop off in nonfarm payrolls is set to reverse in June with the addition of 175k jobs, including the 34k Verizon workers who were on strike during the previous survey period.
This is broadly in line with the 180k market consensus, while analysts at TD Securities and the wider market expect the unemployment rate to push higher to 4.8%.
Wages should post a healthy 0.2% m/m advance, lifting the year-ago pace of wage growth from 2.5% to 2.7%.
Consumer credit growth for May will be released in the afternoon and is expected by TD to accelerate to a $18.0bn pace, above the consensus for an expansion of $16.0bn.