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Cheap British Pound to "Climb Wall of Worry" against Dollar but to Stay Sidelined by the Euro - PSL

JULY 12, 2018

Written by James Skinne

- "The Pound is deemed to be cheap and therefore selling pressure is abating" - Investec

- Theresa May safe until summer 2019, should help Sterling say TD Securities

- But we could see GBP/USD fall sharply below the 1.30 level if Bank of England swerves on August rate rise

Pound Sterling exchange rates

Image © SlayStorm, Adobe Stock

Pound Sterling can climb higher against the Dollar over coming days but will be sidelined by the Euro, according to analysts, as the market digests the recent spate of resignations from Prime Minister Theresa May's government and contemplates the next developments in the Brexit saga.

On Thursday, July 12 the UK government will release its white paper outlining the type of trading relationship the UK would like to enjoy with the EU after Brexit and what will be important for Sterling near-term is the EU's initial response to this white paper.

Expectations for a firmer Pound comes after a period of volatility stoked by Foreign Secretary Boris Johnson who resigned at the start of the week, alongside the Brexit Secretary and a string of junior ministers, in protest over Prime Minister Theresa May having abandoned almost all of her "red lines" in the Brexit negotiations.

The resignations triggered renewed fears of a leadership challenge, or possible collapse of the government, and a sharp sell-off in Pound Sterling exchange rates. But much of this carnage in the market was unwarranted as the Prime Minister's grip on power is stronger than many have given her credit for.

"Two of her most hard-nosed critics, Jacob Rees-Mogg and John Redwood, both came out saying that now was not the appropriate time for a leadership challenge," says James Rossiter, a senior global strategist at TD Securities. "If the leadership vote were to fail to oust her, party rules state that a further vote of no-confidence cannot occur for another full year. So perhaps her critics are waiting to strike at another time."

Conservative Party rules state that when 48 letters of no confidence are sent to the head of the 1922 Committee, a vote of confidence will ensue. The PM needs only a simple majority to survive and following any failed bid to oust her, will be safe from another leadership challenge for 12 months.

The balance of leave and remain supporting MPs in the Conservative parliamentary party, as well as a narrowing window of opportunity to negotiate some form of Brexit deal, means the PM would probably survive an insurrection by angry Brexiteer MPs.

"It therefore looks like, no-confidence vote or not, Theresa May will see out Brexit Day in late-March 2019, with a leadership challenge likely sometime next summer. This would set the stage for a new Prime Minister to take over in time for the party's annual autumn policy conference," Rossiter adds.

The TD Securities team say this should spare Sterling from any further losses and facilitate a steady grind higher in the Pound-to-Dollar rate. Although the Pound-to-Euro rate is likely to remain capped by a ceiling in the region of 1.1325.

"If the tails risks of a snap election or hard Brexit are averted, we see room for GBP to chew into its heavy risk premium, which favours buying into dips near 1.32," says Mark McCormick, North American head of FX strategy at TD Securities. "EURGBP likely to find intraday support near 0.8830. Still, the improving growth backdrop suggests EURUSD offers a cleaner play in the very short-run and we prefer to use dips as buying opportunities towards the 1.1680/50 zone."

A firm support for the EUR/GBP exchange rate around 0.8830 means solid resistance for the Pound-to-Euro exchange rate at 1.1325, suggesting any move above this latter level is unlikely to be sustained in the short term.

"The Pound has tended to be the main barometer of market sentiment towards political developments, so it is instructive to see how it has reacted," says John Wyn-Evans, Head of Investment Strategy at Investec.

The message from the market seems to be twofold says Wyn-Evans:

"First, there was little optimism of a firm outcome going into the talks, so the latest setback is hardly surprising;

"Second, and perhaps more encouragingly, the Pound is deemed to be cheap and therefore selling pressure is abating."

Certainly, most work that Investec see on the subject takes the view that Sterling offers good value on long-term models such as the Real Effective Exchange Rate and Purchasing Power Parity, "although such value measures are notoriously poor at defining where a currency should be trading today," cautions Wyn-Evans.

 

Bank of England Can't Swerve from August Rate Rise Though

What also matters for the Pound are hopes of a Bank of England interest rate rise in August are kept alive, which is a tall order given the Monetary Policy Committee has made clear future policy moves are subject to a "smooth" and orderly Brexit.

Presumably, a government falling apart at the seems would heighten the risk of a disorderly Brexit and prevent the Bank of England from raising interest rates. This would be bad for the Pound as financial markets are assigning a heavy probability to the prospect of a rate hike next month and some are now warning of steep losses for the British currency if the BoE disappoints.

"Prior to yesterday’s events, the UK OIS curve had been pricing in a 79% probability of an August rate hike," says Viraj Patel, an FX strategist at ING Group. "We saw GBP’s intraday post-Johnson slide yesterday coincide with a fall in short-sterling rates and a dip in August rate hike odds (which now stands at 66%). Were this to be fully priced out (ie, effectively drop to 0%) – then we could see GBP/USD fall sharply below the 1.30 level."

Interest rates are a key driver for most moves in currency exchange rates. Changes in rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

Patel and the ING team say that UK politics will be the greatest influence over expectations for Bank of England monetary policy during the months ahead, as the UK's future relationship with the EU will be determined at the political level but will have far-reaching consequences for expert forecasts for UK inflation and economic growth in future years.

The Pound-to-Dollar rate was quoted 0.13% higher at 1.3270 during the noon session Tuesday while the Pound-to-Euro rate was up 0.51% at 1.1330.

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