Sterling Month Outlook (1 – 3 Months)– Grinding higher

After an initial spike in the immediate aftermath of the Conservatives' unexpected election victory, GBP has continued 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, a re-tighten relationship would be expected and, relative to a very flat forward curve, analysts see scope for at least moderate GBP outperformance, according to RBC Capital Markets. 

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. RBC Capital Markets' 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, the GBP continues to grind higher on the crosses as UK rate expectations rise, says RBC Capital Markets.