Sterling Bounces Back

Sterling rallied hard last week, following a clear hawkish shift by the Bank of England on Thursday.  GBPUSD hit a post Brexit high above 1.36, and GBPEUR pushed into the mid-teens, dampening the talk of GBPEUR parity that had begun to creep back into market discourse in recent weeks. GBP’s recovery was something we did expect – we set a 12-month target for GBPUSD of 1.40 back in May – and now that this level is in sight (the market-implied probability of us hitting 1.40 in 2017 is now 50.1%!), we examine the factors which we expect will determine sterling’s value in the coming months.



Monetary Policy – Bullish


Thursday’s Monetary Policy Committee (MPC) meeting took markets by surprise, with the Bank of England stating that it would be appropriate to tighten policy “over the coming months”.  The interest rate futures markets, which had not been pricing in a UK rate hike until the end of 2018, promptly adjusted, moving the expected rate hike a full year forward to December 2017.  Markets now expect the Bank of England to hike before the Fed, something which would have seemed almost inconceivable a few days ago.  This adjustment to Bank of England policy bias will continue to support GBP in the months ahead; just look what happened to the Canadian dollar when the Bank of Canada recently switched from a dovish to a hawkish bias –  the loonie rallied by over 11% in four months.



Positioning – Bullish / Neutral


Going in to the MPC meeting last Thursday, the speculative market was heavily short the pound, with the CFTC futures contracts showing a net short position of 46.1K.  Whilst this was nowhere near the record set back in March, when the short positioning exceeded 100K contracts for the first time, it still was evidence of a market that was not expecting the pound to rally.  This net short position was likely at least partially responsible for sterling’s rally last week, as hedge funds were forced to rapidly cut losing positions.   However, we expect that last weeks’ action will have largely balanced out the market, which could slow any further momentum for the pound. 



Technicals – Bullish


I am far from the world’s most talented or committed technical analyst; I cannot prevent my cynicism from leading me to believe that a lot of technical analysis is nothing more than a specialized form of pareidolia – the psychological phenomenon that causes us to see faces in clouds, rock formations and other inanimate objects.  



Chart I: Pareidolia




However, technical analysis can give us a general sense of trends and momentum, which can be powerful market forces in the short term. 



Chart 2: Technical Analysis (GBPUSD)




The chart above shows GBPUSD, along with its 25-day moving average (red) and its 10-day moving average (green).  These two lines crossed over in early September, presaging a change in trend from bearish to bullish – and GBPUSD has since rallied by about 6 cents.  The technical indicators continue to look quite positive for sterling, and certainly would not indicate an imminent pull-back.   



Valuation – Bullish


One of the biggest reasons for our constructive view of the pound post-Brexit has been valuation (valuation was also the reason we were very bearish on the pound before Brexit).  Currently, our models (which are based primarily on a purchasing power parity (PPP) approach) show GBPUSD fair value at about 1.45, with GBPEUR coming in around 1.20.  In other words, GBP still looks undervalued by a little more than 5% or so at current levels – not a huge amount in the context of PPP analysis, but certainly more bullish for GBP than bearish. 



Geopolitics- Bearish


While our analysis looks good for sterling so far, there is one massive black cloud still lurking malevolently on the horizon.  As long as Brexit and general political chaos continue to dominate UK headlines, it is hard to envision too much more upside for sterling.  The risk of an unsuccessful Brexit combined with an anti-business Corbyn government would be catastrophic for the pound – think parity in GBPUSD rather than GBPEUR!  Our base case view is that Brexit is generally in the price when it comes to the pound – hence relatively bullish forecasts in both GBPUSD and GBPEUR.  We still assign a low probability to the bad Brexit + Corbyn scenario – but the mere existence of this possibility will cap any GBP strength for now.  


Author: Kevin Lester



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