FxWirePro: Sterling spikes in consolidation phase but not out of the woods amid BoE and Brexit

Rarely is a currency outlook quite as uncertain as GBP’s at present? Sterling clearly gained ground over the last few days, probably not least due to the latest reports about the Brexit negotiations. Amid the consolidation phase of GBPUSD, it has bottomed out at 1.1986 levels and bounced back to the current 1.3066 levels (i.e. shy above 9% in just six and a half months).

The list of imponderables has been dominated by politics over the past year - the overarching issue of Brexit of course followed by the indecisive general election which could yet alter the contours of Brexit and fiscal policy. Over the past month, however, the prosaic issue of monetary policy has come to dominate. The BoE surprised observers by signaling a less patient attitude to the continued rise in inflation even as the economy continues to slow (3% inflation, 1% growth).Three of the eight MPC members voted to hike in June, up from two in May, and the Governor and the chief economist, both of whom voted for steady policy in June, subsequently articulated arguments for starting to remove monetary stimulus.

It seems that the British government wants to major steps towards the EU in the upcoming round of negotiations, which will start today. It has for example admitted by now that it would meet its financial obligations towards the EU – an auspicious beginning. After all, the so-called “Brexit bill” had already caused tensions ahead of the negotiations.

Still, it remains to be seen whether the two sides can agree on the size of the bill. The situation remains difficult for the GBP, however, as the recent reports of domestic political quarrels in the UK show. Chancellor of the Exchequer Philip Hammond complained during the weekend that some cabinet members were undermining his efforts to ensure a “soft” Brexit.

Hammond, in turn, is accused by these cabinet members it appears, of wanting to prevent Brexit. This apparent, deep split within the government is ominous. In the short term, it may not be a breakdown of the Brexit negotiations, but a breakdown of the British government which is the biggest risk for Sterling.

We don’t want to rely too much on our own longer-term forecasts, but there are two key points that affect the outlook for the currency. The first is that the story of relative growth trends is one of the euro area catching up with the US and UK, which is why the ECB is edging closer to normalizing its monetary policy.

And the second is that however negative the economic effects of Brexit prove to be (we think it will be corrosive, rather than a short sharp shock), they are a UK-specific drag on growth, which will keep UK monetary policy more accommodative and weigh on the pound, particularly against the euro. 

One piece of good news is that the UK balance of payments has improved sharply thanks to a big improvement in the primary income balance, which captures earnings from the foreign investment.