Starry-eyed BoE not enough to offset short-term political risks for the pound

While the unanimous 9-0 MPC decision for a 25 basis point hike, higher-than-expected nominal neutral interest rate estimate (2-3%) and the overall constructive UK economic outlook are all medium-term positives from today's BoE meeting, the post-meeting decline in the pound should not be all that surprising given the Brexit risks that lie ahead

Opinions
2 August 2018
021117-image-mark_carney.jpg
Source: Bank of England

Bottom line: Short-term GBP bears, long-term GBP bulls

Today’s hawkish Bank of England rate hike was no game-changer for our short-term bearish GBP view – as we feel that Brexit political risks will continue to weigh on the currency over the coming months. We have pencilled in a 1.27-1.28 trough for GBP/USD to reflect peak ‘no deal’ Brexit risks (EUR/GBP risks moving up to 0.91-0.92). However, the relatively more hawkish BoE that we've seen today may buffer some of the possible downside GBP risks – and we still remain medium-term bulls, looking for GBP/USD at 1.38-1.40 and EUR/GBP at 0.85-0.86 in 1Q19. Catalysts for this sharp positive GBP re-rating will be (1) an agreed withdrawal deal and resolution on the Irish border 'backstop' dispute and/or (2) positive UK economic data surprises that oppose short-term Brexit risks. Both at this stage seem more of a 4Q18 story.

Tough to price in BoE's optimistic rate hike outlook just yet

Investors are aware that the Bank’s economic assessment has to be conducted with the rose-tinted glasses of a smooth Brexit adjustment – and not necessarily factoring in the worst-case outcome (a cliff-edge Brexit) as a central scenario. This is not a view that everyone in the market currently shares – not least given recent political development and heightened noise of a no-deal Brexit. Hence as we noted in our preview, hawkish BoE rhetoric alone today was never going to be the catalyst for driving short-term UK rates – or the pound – higher in the near-term.

The lacklustre reaction in GBP can be primarily linked to the lack of willingness for investors to bring forward their expectations for the timing of the next BoE rate hike. The UK OIS curve has barely budged following the BoE meeting (see below) – with markets still seeing 2H19 as the next likely period for when the Bank will hike again. This makes sense – while under normal circumstances one could conceivably pencil in a February or May 2019 BoE hike following today’s meeting, the likely political turbulence in the near-term – with Brexit talks in a crucial phase – means that markets will remain reluctant to price this in.

Source: ING, Bloomberg
ING, Bloomberg

Today’s BoE meeting has no major implications to our GBP view: we continue to think the pound will remain under pressure in the near-term as the currency continues to price in a significant degree of political uncertainty. We do feel the balance of risks is for further political turbulence between now and October – and have pencilled in a 1.27-1.28 trough for GBP/USD in 3Q18 to capture peak ‘no-deal Brexit’ risks (we see EUR/GBP at 0.92).

However, we remain constructive on the medium-term prospects for GBP – given our house-view that a politically acceptable withdrawal deal will be struck between the UK and EU.

  • Based on the BOE’s latest r* estimates, we note that the term structure of UK interest rates is around 75-100 basis points too low right now (see chart below). Long-term UK interest rate expectations will remain distorted by Brexit no-deal risks in the immediate future – and any sustained shift higher in the UK curve won’t transpire until some of these Brexit tail risks have been concretely taken off the table. Indeed, throw into the mix the unique Brexit uncertainties surrounding the UK economy – and this renders r* an almost redundant factor for UK rate markets right now. Indeed, when we think about the conceptual factors that drive r* – demographics, productivity, fiscal policy, savings-investment imbalances, demand for safe assets – one could argue that these would look inherently different in a ‘soft’ versus ‘hard’ Brexit world.
  • We’ll also need to see actual signs of a UK economic recovery – and positive UK data surprises over coming months could also lift short-term domestic rates and the pound. Our medium-term bullish GBP view – which sees GBP/USD at 1.40 (EUR/GBP 0.85) at the turn of the year – is partly based on this structural re-pricing in UK interest rates.

Source: ING FX Strategy
ING FX Strategy

Author

Viraj Patel

Viraj Patel

Foreign Exchange Strategist

Viraj is an FX strategist at ING. He has been with the firm since January 2015 and covers developed markets. Prior to this, he worked at Barclays and the Bank of England. Viraj read Economics at the University of Cambridge and is currently working towards his CFA charter.

Viraj Patel is no longer part of the ING THINK team


Disclaimer

"THINK Outside" is a collection of specially commissioned content from third-party sources, such as economic think-tanks and academic institutions, that ING deems reliable and from non-research departments within ING. ING Bank N.V. ("ING") uses these sources to expand the range of opinions you can find on the THINK website. Some of these sources are not the property of or managed by ING, and therefore ING cannot always guarantee the correctness, completeness, actuality and quality of such sources, nor the availability at any given time of the data and information provided, and ING cannot accept any liability in this respect, insofar as this is permissible pursuant to the applicable laws and regulations.

This publication does not necessarily reflect the ING house view. This publication has been prepared solely for information purposes without regard to any particular user's investment objectives, financial situation, or means. The information in the publication is not an investment recommendation and it is not investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Reasonable care has been taken to ensure that this publication is not untrue or misleading when published, but ING does not represent that it is accurate or complete. ING does not accept any liability for any direct, indirect or consequential loss arising from any use of this publication. Unless otherwise stated, any views, forecasts, or estimates are solely those of the author(s), as of the date of the publication and are subject to change without notice.

The distribution of this publication may be restricted by law or regulation in different jurisdictions and persons into whose possession this publication comes should inform themselves about, and observe, such restrictions.

Copyright and database rights protection exists in this report and it may not be reproduced, distributed or published by any person for any purpose without the prior express consent of ING. All rights are reserved.

ING Bank N.V. is authorised by the Dutch Central Bank and supervised by the European Central Bank (ECB), the Dutch Central Bank (DNB) and the Dutch Authority for the Financial Markets (AFM). ING Bank N.V. is incorporated in the Netherlands (Trade Register no. 33031431 Amsterdam).