Sterling can fall much further – Deutsche Bank

Oliver Harvey, Macro Strategist at Deutsche Bank, points out that Sterling has been the worst performing G10 currency this year and the main push-back against their continued bearish GBP call is that Brexit is fully priced and the pound looks cheap against fair value metrics.

Key Quotes

“We disagree.

1. Financial fair value metrics point much lower. An average of forward and current two year nominal rate spreads, the measure we find has the tightest correlation to GBP/USD, currently points to sub-1.10, while a regression of the same over the last 5 years points to 1.14 – our target for H2. EUR/GBP has had a less robust relationship with rate spreads, but also looks slightly cheap.
2. Longer-run valuation metrics are not stretched. Sterling is still not cheap on a PPP basis, according to our latest valuation snapshot. Most importantly, the UK’s current account hasn’t improved as the trade deficit, excluding oil and gold exports, makes record highs.
3. Inflows are drying up again. To finance the trade deficit, the UK needs to continue to attract capital, but foreign purchases of gilts turned negative in December and January as reserve rebalancing slowed. Meanwhile, our cross-border M&A monitor shows net inflows have turned negative again this year, after a brief bounce in the autumn.
4. Growth expectations are not pricing hard Brexit. If Brexit is fully priced, the market has a benign view of the outcome. Consensus estimates for 2017 GDP have risen to 1.6%, from a nadir of 0.5% shortly after the referendum. This is only a 0.2% slowing from last year. But recent weakness in retail sales shows household spending is responding to slowing employment and rising shop prices. Much has been made of robust UK PMIs, but this is due to stronger global growth. Indeed, the UK’s manufacturing PMI is turning lower even as global PMIs make new highs.
5. Political risks have yet to materialize. Finally, Brexit negotiations have yet to start. Arguments over the divorce bill may generate negative mood music, but the main issue is sequencing. Little progress in talks is likely before a new German government is in place by the late autumn, leaving less than a year to conclude a new relationship with the EU before ratification by the EU Parliament. This is completely unrealistic, and until a transitional deal is agreed, the market will be forced to increasingly price a cliff-edge Brexit.”

“The main risk to the view is positioning, with the IMM report showing sterling shorts are at high levels, albeit our own CORAX report shows a more nuanced picture, with real money, in particular, turning more bullish. We also don’t rule out two dissenting votes from the Bank of England on Thursday and the MPC’s attitude to the apparent shift in fiscal stance this year at last week’s budget will be important. Yet, we don’t see rate hikes this year as credible given the slowdown in momentum noted above. So, we maintain our existing Blueprint recommendations of short GBP/USD and short GBP/CHF.”