GBP USD - FUNDAMENTAL ANALYSISIn a fresh look at the outlook for the Pound to Dollar (GBP/USD) exchange rate, Jane Foley, Senior FX Strategist at Rabobank, draws attention to a potential slide for the sterling.
"We see scope for cable to drop to 1.22 on a 3-month view," says Foley, Senior FX Strategist at Rabobank. This outlook indicates a drop in the value of the pound against the dollar by more than one per cent from its current position.
The basis of this outlook, according to Foley, appears to be linked to market positioning and the capability of both the pound and the euro to handle impending disappointing economic data. The narrative surrounding these factors suggests a period of increased volatility for the pound, especially against its major counterparts.
A surge in gilt yields and revived anxieties around UK's fiscal management have the potential to disrupt Pound Sterling (GBP)'s recent strength against the US dollar (USD), according to the analyst.
This is in light of market expectations of additional Bank of England (BoE) rate hikes, which have failed to solidify GBP/USD's initial gains against major currencies.
"Yesterday’s headlines that gilt yields had soared back towards the levels hit after the disastrous mini-budget last September was unsettling for investors and for the pound," says Foley.
Further, despite market expectations of BoE rate hikes, "the Pound failed to hold initial gains against either the USD or the EUR," Foley adds.
Q1 Performance and Market Positioning of the Sterling
In terms of the sterling's performance, the currency had a strong showing in the first quarter.
Data from this period suggested that the UK economy was outperforming expectations, earning the sterling the title of the best-performing G10 currency.
Despite these positive indicators, Foley posits that the UK's growth outlook remains far from robust.
"The Pound was the best performing G10 currency in Q1 as a stream of UK data suggested that the economy was performing better than expected," says Foley.
However, Foley points out that, "The UK growth outlook is still far from strong."
Market positioning towards the sterling has shown a shift in Q1.
Speculators have moved from short GBP positions to net long GBP positions.
However, recent data showing stronger-than-expected UK CPI inflation has reintroduced fears of a potential recession.
BoE Policy and the Potential of a UK Recession
Looking ahead, the BoE's policy decisions might bear heavily on the GBP/USD exchange rate.
The possibility of the BoE raising the Bank rate to 5.0% or even higher is under consideration.
This raises a serious question: would the BoE need to push the UK economy into recession to restore CPI inflation to its 2% target?
"The risk that the BoE will have to raise the Bank rate to 5.0% or maybe higher has clearly increased," says Foley.
She goes on to add, "The first is whether the Bank will have to push the UK economy into recession to restore CPI inflation to its 2% target."
Impact of Brexit on the Pound Sterling
The long-term implications of Brexit are also critical to understanding Pound Sterling's position.
The UK's high inflation rate, which is the highest in the G7, alongside other fundamental weaknesses, have caused some to question whether these issues stem from the aftermath of Brexit.
"The UK has the highest inflation rate in the G7, a soft growth outlook, a weak record on investment and productivity growth in recent years," Foley points out.
She continues, "Inevitably, this has raised questions about how much of this is related to Brexit."
Moreover, the sterling's decline to its pre-2016 Brexit referendum levels appears to have impacted price levels in recent years, with changes in post-Brexit trading arrangements possibly causing further economic turbulence.
"GBP has never returned to its pre-2016 Brexit referendum levels which likely had had an impact of the price level in recent years," says Foley.
UK’s Economic Sensitivities and Recession Risks
The UK's particular economic sensitivities may also be playing a role in the inflation scenario. For instance, the UK's high dependency on gas and small agricultural sector could increase its sensitivity to energy crises and food supply shortages.
"The UK has little gas storage and a high level of dependency on gas which would have raised its sensitivity to last year’s energy crisis. It also has a very small agricultural sector which has likely increased its sensitivity to supply shortages of food," Foley highlights.
These factors, coupled with the risk of higher interest rates, brings the possibility of recession back into focus. According to Foley, speculators who took long GBP positions recently may have acted hastily, considering these lingering threats.
"Either way the risk of higher interest rates means that recession risks are back in the sights, just as forecasters such as the IMF had indicated that the UK would avoid this scenario this year," Foley mentions.
Comparatively, Kit Juckes, Global Head of FX Strategy at Société Générale Juckes expects depreciation of Pound Sterling (GBP) given the UK's high current account deficit and the global interest rate environment.
On the other hand, Shaun Osborne, Chief FX Strategist at Scotiabank envisages Pound Sterling (GBP) potentially benefiting from higher yields in the short term, but warns of a probable depreciation due to the UK's fundamental weaknesses.
