GBP is forecast to remain under sustained pressure against the Dollar for some time owing to the downward trajectory in real rates says a leading foreign exchange analyst.
Pound Sterling has recovered back above 1.27 against the Dollar at the time of writing partly on the back of some better-than-forecast UK economic data but mostly as a result of tactical profit-taking by investors.
That investors are keen to cut back on negative exposure to Sterling following a recent strong run is not surprising.
"People will be starting to think, yes, we’ve had some newsflow about Brexit, but does this really imply that we’ll have a hard Brexit - isn’t it still more likely we’ll have a soft Brexit? It’s a perfect time to take profit because this kind of newsflow that’s been hitting Sterling in the last few days now abates," says Ulrich Leuchtmann, head of currency strategy at Commerzbank.
As the Conservative Party conference brings Brexit back into the spotlight we have seen Sterling trade fresh 31 year lows, sub-1.27.
We have also seen GBP/EUR fall below 1.1364 for the first time since the first quarter of 2013.
Over the weekend Theresa May took the proverbial stick in hand and drew an emphatic line in the sand before party members promising Article 50 would definitely be triggered by the end of March 2017.
The fall in the Pound Sterling following Theresa May’s Conservative party conference speech has taken Societe Generale's FX analyst Kit Juckes by surprise.
“Confirmation that the UK Government plans to trigger article 50 by the end of Q1 2017 hit Sterling harder than I expected,” says Juckes in a recent note to clients.
The GBP/USD closed September at 1.2978 and by Wednesday 5th October FX markets were looking at the weakest value in the pair since February 1984 with a low of 1.27 being seen.
The analyst says some sort of a bounce is possible but believes the noises from the Conservative party conference aren't helpful.
“The government isn't showing any signs of shifting a position where control on immigration is the hardest of lines in negotiations to leave the EU, and this won't be sacrificed or watered down in order to keep access to the single market, particularly for financial services," says Juckes.
"There's nothing there to soften the outlook for Sterling, at all."
Juckes argues the primary driver of the GBP/USD exchange rate is the difference between central bank interest rates.
Currencies with higher interest rates tend to attract more flows of capital from foreign investors seeking higher returns, which tends to strengthen the currency.
At the moment the difference between UK base interest rate at 0.25% and US base interest rates at 0.5% is only 0.25% in favour of the dollar.
According to Juckes, however, this existing advantage is set to widen by December, as the difference between Sterling futures and Eurodollar futures contracts are indicating a 0.75% difference between UK and US rates in December ‘16.
This will place further downside pressure on the exchange rate.
This is likely to be as a result of the Federal Reserve raising interest rates in the US to 0.75% and the BOE cutting rates in the UK to zero or 0.10%.
Both of these outcomes are possible, with markets currently pricing a 60% chance of a hike in the US by December.
And although recent data in the UK has been good enough to put off the time the Bank of England (BOE) might cut interest rates again, it may not be enough to shut the door completely.
“Sterling will get support from the economic data only if their resilience lasts long enough to challenge the view that rates will be cut again due course. The better recent data clearly reduce the chances of a near-term cut, but that doesn't matter so much as what happens over the next year or so,” comments Juckes.
What this means for the exchange rate is that it will probably continue tumbling well into the 1.20s.
“If I extrapolate the correlation between GBP/USD and rates, GBP/USD 1.25 is reached if the market prices a 12-month forward rate differential of 1%.”
A GBP/USD 1.25 exchange rate by October 2017 infers a 1% difference between UK and US interest rates – either by the Fed hiking rates in the US by one whole percent (four rate rises) to 1.5% or a combination of a cut in the UK to 0.1% and three rises in the US to 1.25%, which would result in 0.9% difference, which is nevertheless close enough to 1.0%.
Juckes’ final forecast for GBP/USD is for it to reach a low of 1.23.
“To get Sterling below 1.20 we need the market to price much more Fed hiking, or the UK economy to be in poor enough shape that these simple rate/FX correlations break down. For now, our base case is still for a low of GBP/USD 1.23 in March.”
But, Some say the Pound is Now Undervalued
Indeed, the market is still very negative on the GBP with speculative market positions remain stretched to historical extremes: net speculative shorts are nearly 2 standard deviations above the historical mean.
The consensus forecast for the GBP/USD at year-end is 1.27.
However, not everyone agrees with the view that the only way is down for Sterling.
Aurelija Augulyte, currency analyst with Nordea Markets believes the GBP is already undervalued by most long-term measures; the PPP suggests the GBP/USD cross is some 10% too low relative to fair value.
While domestic politics matter, global factors will play a big role in the coming months too.
"As the GBP remains the most “risky” of the G4 currencies, higher oil prices, long yields and in general positive risk sentiment, which we expect into the year-end, should be GBP supportive," says Augulyte.
Nordea Markets are thus more positive than the consensus and see GBP/USD higher by end-year, at 1.32, and EUR/GBP at 0.84.
Eyes Turn to US Non-Farm Payroll Report
With sentiment likely to wane as a factor behind GBP/USD moves we could well see data take centre stage once more.
With that in mind we await the release of non-farm payroll data in the US Employment Situation Summary report due for release on October 7th.
As always traders will be looking for a strong reading to signal whether a December interest rate rise at the US Fed is possible.
Economists are forecasting a reading of 175k, a notable beat of this figure could well see the US Dollar complex rally and in the process the GBP/USD could be at risk of testing multi-year lows again.