GKFX – GBP a Case of Avoiding banana skins - 021215
Sterling has appreciated strongly this year despite softer growth and BoE lift-off being delayed until well into 2016. With the Pound becoming a default beneficiary of external weakness and QE. It was also further helped by a somewhat surprising general election result that temporarily lifted political risk.
We think that 2016 should be more nuanced. Albeit still net positive for Sterling whilst we expect diminishing FX impact from overseas QE. This places greater emphasis on the BoE finally delivering to sustain GBP’s uptrend. The BoE’s sensitivity to FX pass-through should also limit further gains even if the monetary policy committee (MPC) does get going in May.
Politics looms large again though in the form of the EU referendum. The economic consequences of Brexit are potentially profound. And the vote should command a risk premium in spot.
Brexit odds are running at 20%, perhaps 30%. But benchmarking the FX impact of a vote to leave is little more than guesswork at this stage. We assume a 5% hit to the GBP index near term. This could extend to 10% if reserve managers sell and expose fragile current account fundamentals.
A Brexit risk premium though is starting to be priced into options and this will intensify once a date is set. We favour a 1 year bearish risk-reversal in cable (temporary Fed-BoE policy divergence could weaken cable before the political risk premium kicks-in mid-year).
The timing of the vote will determine the precise contours of Sterling in 2016. For illustration we assume a Q3 vote and a 2% pre-referendum dip in GBP in 2Q. Where Cable would fall to 1.47 and EUR/GBP to 0.70/71.
Cable is expected to end 2016 at around 1.57 and EUR/GBP at 0.72 assuming a vote to remain in the ‘club’ . JP Morgan sees the EUR/USD recovering to 1.13. but Brexit should take cable to the low 1.40s and EUR/GBP to the mid 0.70s. A vote to remain in accompanied with accelerated rate hikes would take cable to 1.62-1.63 and EUR/GBP to 0.66-0.67.
JPM Trade idea would be to : Buy a 1Y 25D GBP/USD risk reversal to hedge Brexit risk.
But Others' woes, have been GBP’s gain
The bare numbers reveal this to be a pretty good year for GBP. A gain of 6% on the index and a 9% gain against the euro and the losses against a resurgent dollar have been limited to only a few percent. Only the newly liberated CHF did better.
What the numbers don’t convey is the absence of any overt UK-centric justification for the pound’s strong showing. This makes it even more impressive. The general election delivered an unexpectedly favourable outturn of political continuity.
But set against this was a further cooling in UK growth from 2.5% to 2% and a marked slowdown in the pace of labour market tightening. There was also a pronounced drop in core inflation.
So GBP is perhaps the best illustration this year of the relative nature of FX. In that what happens externally is just as important for the exchange rate, and occasionally more so, than local factors.
In GBP’s case the impression is that external weakness was a far more important driver of GBP than anything domestic. In particular, QE by the ECB and BoJ was instrumental in lifting GBP.
GBP benefited by default from even more dovish global developments. The lion’s share of this year’s GBP rally can be empirically ascribed to the ECB and BoJ. Only one-fifth is explained by wider GBP rate differentials.