For once, both the polls and the betting markets got the result right! What very few anticipated, was the magnitude of the Conservative majority – the largest since 1987. Unsurprisingly, the news saw sterling jump to ($1.3514) its highest level against the dollar since May 2018 and its highest against the euro (€1.2045) since July 2016! With the pound set to close 2019 as the best performing currency amongst the G10, the question on our all our minds is what can we expect to happen to the pound in 2020?
There are a number of key factors to consider:
1. First and foremost, the Government needs to address the impending 31st January 2020 withdrawal agreement deadline. With a very large majority, Boris Johnson should have no problems getting his deal through the House of Commons when he next presents it to MPs. This is set to happen on Friday, after the Queen’s speech on Thursday. Theoretically, it is possible MPs could block the deal again, but this is now highly unlikely.
Assuming the withdrawal agreement is passed, and a no-deal Brexit on 31st January 2020 is averted, the focus will switch to trade deal negotiations and Britain’s future relationship with the EU after departure. Michael Gove has said a new Brexit deal will be concluded by the end of 2020, a target that isn’t too ambitious given that most of the work has already been completed. However, this may be easier said than done, especially given the contentious issue of the Northern Irish border with the UK mainland and we certainly wouldn’t rule out Johnson requesting an extension to the transition period (due to end in December 2020) towards the back end of next year.
Verdict: Intuitively, it should be relatively straight forward for Boris to get his withdrawal agreement through the House of Commons and we see the associated reduction in risk of a No Deal Brexit as being one of the key drivers behind the rally in sterling. While there may be some small upside potential if/when this is passed, there is obviously a much larger downside risk for the Pound in the event of a problem.
2. The second point for consideration is the UK economic outlook for 2020 and beyond. The result of the election, coupled with better visibility over how Brexit might look, is likely to unlock some pent-up investment that had had previously been held back amid all the uncertainty. Meanwhile, Johnson’s pledge to increase fiscal spending will boost UK growth, particularly in the second half of next year. With unemployment at record lows and wages rising above inflation, there may well be scope for tighter monetary policy from the Bank of England towards the back end of 2020, if not during the first half of 2021.
Verdict: At this stage, the OIS curve is pricing in a 0% chance of an interest rate hike before May 2020. Granted the probability of a cut is also looking slim, but any suggestion of higher rates will certainly have a positive impact on sterling, especially if other central banks around the globe remain accommodative.
3. A third potential risk factor for the pound is the threat of a second Scottish referendum on independence from the UK. The SNP, the only other party to gain seats at last week’s election, claims it has a mandate for an independent Scotland which could separately join the EU. This has been shut down by parties on both sides, with Boris Johnson reiterating his opposition to another Scottish referendum.
Verdict: Although the probability of Scottish independence is very low, the impact would be very high and thus the risk is not insignificant. As we saw back in 2014, the threat of Scottish independence had a significant negative impact on sterling and thus if there was talk of a second referendum, the uncertainty it would create would be highly likely to also have a negative impact on the pound.
4. Market positioning is the closest its been to neutral since May last year according to the latest CFTC data. The fact that there is still a small net short position suggests there may still be some upside for the pound, especially if traders see justification for building long positions. History shows that since the financial crisis, traders have only been net long for brief periods (in 2012, 2014 and 2018). Meanwhile, risk reversals in the options market have reverted to more normal levels following a sharp move lower prior during the first half of December (hedging the downside in sterling temporarily became very expensive). Puts are still marginally more expensive than calls, but not to the point where we can glean any clear signals.
Verdict: With positioning back to neutral and long positions short-lived in recent years, we see a risk that the speculative market finds reason for building new shorts. At this stage, the catalyst could be any of the above points, and could still come from higher levels, but overall, we see reason for being cautious about the downside in sterling.
In conclusion, we see justification for being mildly bullish on the pound in the short term but remain more cautious in the longer term. Looking across the G10, the UK suddenly looks one of the most [if not the most] stable countries from a political standpoint with a very pro-business government. Given that the pound is coming from a low base, and remains undervalued from a long-term valuation perspective, we see scope for further gains in the months ahead. Looking further ahead, we remain a little cautious given sterling’s cyclical nature and where we stand in the overall cycle. As such, we have adjusted our forecasts as follows:
|Q1 2020||Q2 2020||Q3 2020||Q4 2020|
This week we have focused our attention on sterling but when looking at currencies, we should not forget about the other side of each pair. Our first piece of 2020 will set out our thoughts for the US dollar, euro and Canadian dollar in more detail.
This will be our last publication of 2019. We wish all our readers an enjoyable break over the holiday season and best wishes for 2020!
Author: Marc Cogliatti