GBP outlook : RBC

RBC Capital Markets notes:

1-3 Month Outlook - Grinding higher

After an initial spike in the immediate aftermath of the Conservatives' unexpected election victory, GBP hascontinued to grind higher on most crosses, with the BoE TWI hitting a new post-crisis high. With the election behind us, going forward, GBP will to a large degree be driven by conventional monetary policy expectations. Over the last six months, EUR/GBP's correlation to forward rate differentials (generic fifth futures) has been just 0.16 compared to an average of 0.42 over the last decade. 

From here, we would expect this relationship to re-tighten and, relative to a very flat forward curve , we see scope for at least moderate GBP outperformance. On current OIS rates, the market discounts a full 25bp rate hike at around this time next year and there is virtually zero probability attached to a hike before end-2015. 

Our economists' central expectation of a November hike is therefore far ahead of market expectations and, if market expectations converge to that view it would not be unreasonable for GBP to outperform as rate hikes are priced into the curve. 

There are a number of risks to that view: the Conservatives' first budget without coalition constraints (July 8), imminent policy speeches at the Mansion House (no date set), incoming data, earnings data in particular. Notwithstanding these risks, our central view is that GBP continues to grind higher on the crosses as UK rate expectations rise.

6-12 Month Outlook - Referendum risk overstated

Longer-term, another risk for GBP will come into focus - that the UK electorate votes the country out of the EU in the referendum, promised by end-2017. Subsequent to the election, the implied probability of UK exit has risen sharply (to around 30%; Figure 2), yet the impact on GBP so far appears to be negligible. 

In reality, an event which is still up to 2½ years in the future has limited "present value" in FX markets. This could change, of course, as the referendum draws closer or as the risk of an "exit" vote rises. But when we looked at this in detail, we concluded the UK electorate is probably less Eurosceptic than the probabilities or recent opinion polls imply. 

EU exit is not the only longer-term risk for GBP, though the others (e.g. the large internal and external imbalances) are sustainable for longer under political stability than they would have been under less stable election outcomes. We maintain a moderately constructive long-term view on GBP.