HSBC GBP Special: Forecast change – The bounce before the trounce
- We were wrong. Contrary to our expectations, GBP has been exclusively driven by cyclical forces in 2017
- Combined with a more hawkish BoE, we revise our year-end 2017 forecast for GBP-USD higher, from 1.20 to 1.35
- But GBP is likely to weaken in 2018 as the market questions the merit of rate hikes and politics belatedly gets a grip on it
The Bank of England’s unexpected hunger to join other G10 central banks in the race to the exit from accommodative monetary policy has given additional impetus to GBP, a currency that has happily ignored the political intrigue of Brexit throughout 2017. The market obsession has been on rate differentials alone, a perspective that has been at odds with our bearishness. We admit defeat for 2017 and revise our year-end target to 1.35 for GBP-USD and 0.89 for EUR-GBP.
Bloodied but unbowed, we turn to 2018 and look for GBP weakness. The ticking clock on Brexit negotiations is likely to lend politics greater influence, especially if progress remains difficult to come by. GBP’s tight relationship with the interest rate outlook suggests very little is in the price for political risk, a complacency which opens up asymmetric downside risks. Added to this threat, however, the BoE’s zealous rate strategy, which has buoyed GBP recently, could ultimately turn out to be part of its undoing. A couple of rate hikes are unlikely to derail the economy, but if the data even hints at a need for a policy reversal, the impact on GBP could be marked. We look for GBP-USD to finish 2018 at 1.26 and EUR-GBP at 0.95.
2017 – The dominant cycle
We expected 2017 to be a difficult year for GBP, one in which the currency would succumb to the uncertainties that the Brexit vote had unleased and where politics would remain the dominant driver. It was the year when a lack of progress in Brexit negotiations would cause a fretful GBP to ponder a ‘no deal’ cliff-edge conclusion to the Article 50 machinations. Heightened political uncertainty would in turn highlight the UK’s structural frailties. The current account deficit would remain stubbornly wide, encouraging additional GBP downside. Alongside a BoE side-lined by a currency-induced real income squeeze, we had forecast GBP-USD to weaken to 1.20 and for EUR-GBP to reach parity.
The idea of heightened political uncertainty, difficult Brexit negotiations, or persistent trade deficits – is now playing second fiddle to the possibility of a cyclical rate rise. GBP has been swept up in the global race to “normalise”. Nevertheless over time, politics will become front and centre again – but as it would seem not in 2017.
1. GBP has been a slave to the cycle but political risk can influence it
This year GBP has slavishly and exclusively followed only cyclical drivers not the political ones. Chart 1 shows GBP-USD plotted against expectations for 1Y rates a year ahead in the UK compared to those in the US. Prior to the Brexit vote in June 2016, the relationship was neat. During H2 16, the power of political drivers to disrupt this relationship is evident. Yet in 2017, GBP reverted to being a cyclical slave, once again tracking those rate expectations . It’s as though the market has a set and stable idea of the Brexit negotiations.
Such cyclical considerations have been jolted further in GBP’s favour, following the BoE’s pivot towards the exit at its September meeting. They have signalled a hike is likely in the coming months and our economics team believes an additional hike is likely in May 2018. The surprise of the BoE attitude swing suggests the cycle will remain the dominant driver through the end of the year. It means we revise our year-end 2017 GBP-USD forecast from 1.20 to 1.35, in a sense for 2017 we have raised the white flag.
For the next few months, the currency will be driven by whether and how often the BoE will act. The debate about whether they should have tightened will have to wait for 2018.
2018: Politics back to the fore – downside revisited
Chastened by the failure of our high conviction call for GBP weakness in 2017, there is some understandable reluctance to be bearish on it in 2018. We would love to hide in our shelter and let the storm pass. But we honestly believe the ingredients are going to be in place for a reversal lower. We expect the cyclical support to GBP to fade which will open the door to structural frailties and political risk to belatedly exert an influence over GBP. We look for GBP-USD to finish 2018 at 1.26 and EUR-GBP at 0.95.
Fashion faux pas
The Bank of England is not alone in its move to the exit in what has become a fashionable shift in policy among G10 central banks. The Fed, of course, led the charge but the BoC has raised rates recently and 2018 is likely to see other central banks join the tightening club. We forecast hikes from the RBA, RBNZ, Riksbank and Norges Bank and expect their currencies to strengthen as a consequence.
The complication regarding the BoE is that we have some doubts about the merits of this tightening. Indeed, while our economics team has revised their forecasts to incorporate two rate hikes from the BoE, this is largely to reflect the shift in BoE rhetoric rather than a more upbeat assessment of the UK economy. They also believe there is a risk that the hikes may need to be subsequently reversed, which would be a blow to GBP.
The inflation overshoot the BoE has become less tolerant of is largely currency induced and therefore temporary. Indeed, currency weakness is a necessary part of the adjustment to reality of Brexit. It is the adjustment factor to get the current account under control, in part by squeezing real incomes through higher imported inflation. A weaker GBP also helps to keep the capital flowing in, offering UK assets to overseas investors at a discount. Tightening monetary policy undermines that adjustment. It is why we believe a rate hike will ultimately prove GBP negative beyond the standard initial reaction to the shift in rate expectations. These structural considerations must be taken into account.
The rally we have seen in GBP in response to the BoE’s early pivot to the exit requires that the central bank is right to assume that the tight labour market will create higher wages growth. We do not see evidence of this and the BoE has been wrong on this many times before. Although the unemployment rate has consistently been lower than they expected, wages growth has failed to accelerate in the manner anticipated.
The BoE is presumably anticipating that the Phillips curve will at some point kick into action. We shall see. But the other curiosity is that the pivot to the exit comes against a backdrop where the UK economy is not really over-delivering. Chart 4 shows the UK’s economic surprise index where the downward moving line since March 2017 means that the bulk of activity indicators have been disappointing relative to consensus. Or put it another way, the BoE’s hawkish turn comes when there appears to be an excess of optimism on activity relative to the reality of the data.
4. Activity data has generally been softer than expected in the UK
The risk of reversal
At the moment, the market is trying to decipher when and by how much the BoE will raise interest rates. But if wages fail to accelerate in the manner anticipated and consumption continues to wilt under the pressure of the real income squeeze, or investment stutters through the uncertainty of Brexit, the doves may come back into the ascendancy. Our economics team do not expect to rate hikes to crash the UK economy, but they note that if inflation pressures fall back as the impact of earlier GBP weakness recedes, then this prospective tightening may be viewed as premature.
5. GBP is cheap, but it needs to be cheap
The BoE’s shift in mood is fostering a twin-pronged removal of policy accommodation, through higher interest rates and a stronger currency. But the impact will go beyond the cyclical effects. It is also likely to have a bearing on the structural frailties of the UK economy, notably the external imbalance.
We do not dispute that GBP is cheap. Our Little Mac Valuation Index, for example, suggests fair value may be between 13% and 22% higher than spot (chart 5). However, we believe that GBP has to be cheap in order to act as the economic adjustment mechanism for the shock of Brexit.
Chart 6 shows a chart of the UK’s trade balance which continues to hold at unpleasantly pronounced levels. Translation effects on the income part of the current account have helped to narrow the deficit there, but the rally in GBP-USD from 1.20 to 1.35 seen so far in 2017 will be unhelpful. We believe the persistence of the deficits means there is a need for further weakness in the currency to aid the adjustment.
6. GBP has more work to do if the trade deficit is to narrow
Politics – time to get a grip
Why might politics get a grip on the currency in 2018 when it has failed to do so in 2017? One obvious answer is that we are a year closer to the deadline for the end of the Article 50 negotiations. For practical purposes the deadline will be October 2018 if the respective EU parliaments are to have time to get everything agreed and ratified in time by March 2019. The markets have been able to comfortably ignore the lack of progress in EU negotiations so far, reassured that there is still time to get things settled. Such complacency will feel even more ill-advised in 2018 if the negotiations are still struggling.
Perhaps complacency sums up the currency market’s attitude towards the likely evolution of Brexit. Its willingness to focus exclusively on cyclical drivers hints at a market contemplating a soft Brexit outcome, perhaps one where a lengthy transition period means very little is about to change for many years to come. They may be correct, but the tight fit between GBP-USD and rate differentials suggests there is not much political risk in the currency to take account of a less favourable outcome.
Consider the least market friendly alternative – a ‘no deal’ cliff edge departure of the UK from the EU coinciding with a slowdown in the UK economy, raising big questions about whether the BoE made a policy error in raising rates. In our opinion, this could see GBP-USD drop well below 1.20. The longer the negotiations fail to make progress, and the closer we move to the deadline, the greater the probability that the FX market will have to attach to this outcome. As we move through 2018, the currency is likely to increasingly reflect the blend of probabilities for different Brexit outcome scenarios. We were wrong to expect political risk to be a big driver of GBP in 2017. But with the clock ticking towards Brexit, politics may get a grip on GBP in 2018.