GBP/USD Rate to Fall to 1.28 Ahead of Recovery in 2017 say Lloyds Bank

Lloyds Bank have confirmed further downside in the GBP to USD conversion remains available, however there are limits to the weakness with a recovery being seen in 2017.

• GBP/USD closes week at 1.2919, is worst performer in G10
• "GBP/USD remains significantly dislocated from valuations." - Lloyds
• "The GBP adjustment has been severe already but we think there is a little more weakness ahead of the Pound." - Scotiabank.

Having posted its sharpest one-day decline on record in the immediate aftermath of the UK EU referendum, GBP/USD has stabilised in recent weeks to trade within a 1.28-1.35 range.

Within this framework, we hear the British Pound should ultimately break below 1.30 again and head lower to the bottom of the range. 

The call for further, arguably limited, weakness in Sterling comes from Lloyds Bank, who have recently released their latest financial market forecasts.

Of note, Lloyds see downside pressure on Sterling coming from the Bank of England who are anticipated to cut interest rates again in 2016, taking the basic rate to 0.1%.

However, the cut will not punish the GBP as heavily as would have been expected as the Bank approaches its ‘lower bound’ limit.

In short, Sterling weakness is likely to be limited as markets realise the Bank will not cut rates beyond 0.1% noting the ineffectiveness of such measures as per the efforts of the Bank of Japan and European Central Bank.

“The limited scope for lower policy interest rates, however, points to less downside for
GBP/USD,” say Lloyds.

It is noted that implied volatility and the relative cost of insuring against further declines in GBP/USD versus a similar sized rise has fallen back and is close to pre-referendum levels.

This suggests the GBP/USD market is settling into more predictable conditions.

Latest Pound / US Dollar Exchange Rates

	Live: 1.3335▲ + 0.06% 12 Month Best: 1.3789
*Your Bank's Retail Rate	1.2881 - 1.2935
**Independent Specialist	1.3148 - 1.3201 Find out why this is a better rate

* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

“Yet, GBP/USD remains significantly dislocated from valuations suggested by relative interest rate differentials alone, which point to around 1.38 - some 6% higher than the present level,” say Lloyds.

This decline below ‘fair value’ reflects continuing political uncertainty and the associated increase in risk premia since the referendum.

Indeed, with at least two years of political negotiations with Europe ahead, these uncertainties are unlikely to fade fast.

This overarching uncertainty around the political outlook leaves sterling susceptible to significant bouts of volatility.

Near term, the US dollar could benefit from an increase in expectations of a US rate hike in 2016.

“Assuming a further decline in UK Bank Rate to 0.1% and a US rate hike in Q4, we forecast GBP/USD to edge lower towards 1.28 by year end. Thereafter, we expect GBP/USD to remain relatively range bound between 1.30 and 1.35 through 2017,” say Lloyds.

Bank of England to Cut Rates to 0.1%

In August the Bank of England delivered a 25bp cut in Bank Rate – alongside an extension of its quantitative easing programme and a new Term Funding Scheme. (Details on each here).

The aim is to suppress UK lending costs in order to oil investment spending by British businesses.

The Bank Rate is not expected to return to its previous level of 0.50% until around 2022, on prevailing market pricing.

This has seen the GBP decline back towards the early July lows against the Euro and US Dollar, while it has surpassed these lows against others, notably the Australian Dollar.

Near term, Lloyds believe a further cut in Bank Rate is likely, with the Bank of England indicating that a majority on the MPC was in favour of cutting the rate to its ‘effective’ zero bound at the August meeting.

“While the BoE has so far carefully avoided specifying the precise level of this lower bound – beyond indicating that it judges it to be “close to, but a little above, zero” – our base scenario sees Bank Rate being eased to 10bp at November’s policy meeting, alongside the next update of the Inflation Report projections,” say Lloyds.

Scotiabank: Bulk of British Pound Decline Against Dollar May be Behind Us

It is not only Lloyds who have reported studies that suggest Sterling is undervalued on some measures. 

Scotiabank's value estimate for spot Sterling-Dollar, based on spot regressions with short-term spreads and relative equity returns (R2 of 0.87 on daily data since 2013), shows GBP/USD is somewhat undervalued. 

"Relative to our equilibrium estimate of 1.3350. Spot is about 1 standard deviation below FV from this perspective and further near-term GBP weakness may be hard to sustain, without spreads, data or financial markets moving more obviously against the GBP," says Shaun Osborne, Chief FX Strategist with Scotiabank Global Banking and Markets in Toronto, Canada..

Nevertheless, Osborne and his team expects fundamental developments to be fully supportive of a lower GBP valuation moving forward.

Looking at exchange rate valuation based on the deviation in spot from PPP supports the idea that the bulk of the GBP’s decline might already have been seen.

“The GBP tumbled in the wake of the referendum and we reduced our year-end target for GBPUSD as a consequence (to USD1.25). The GBP adjustment has been severe already but we think there is a little more weakness ahead of the Pound,” says Eric Theoret, FX Strategist at Scotiabank.

GBP/USD Technical Outlook: Rebounds Represent Good Selling Opportunities

What are the charts telling us - do they marry with the fundamental projections laid out by Lloyds?

Technical signals suggest that GBPUSD weakness is a question of time only, argues Osborne, whose recent analysis of Sterling combines both a fundamental approach (as per above) and a technical approach. 

According to Osborne, "GBPUSD’s break under the base of the July triangular consolidation targets an immediate move to 1.26 in the next 2-4 weeks."

"Still lower levels remain technically possible, if not likely, given the alignment of strong, bearish trend strength signals across a range of short, medium and longer-term timeframes which underscore the power of the underlying move lower in GBPUSD from a technical perspective."

Fundamentally and technically, Scotiabank think minor GBPUSD rebounds near-term represent good selling opportunities.