Sterling’s rough ride over the past four years have meant its moniker as the “North Atlantic peso” has remained a popular joke in FX circles. However, despite some recent assertions to the contrary, the pound does not trade like an emerging market currency, and is likely to rally with the rest of the G10 against the US dollar as the global economy undergoes a gradual and inconsistent re-opening.
In the short run, we believe sterling will join the rest of the G10 currencies in rallying against the greenback, but that the rate will be less than impressive in 2020 while some Brexit risk persists.
Our base case for trade talks with the EU remains that the most likely outcome is a free trade agreement covering goods. As always, there is a significant risk of collapse and a disruptive end to the transition period. By our subjective judgement this likelihood is around 25% probability. Once this uncertainty is resolved in 2020, we believe the pound will have room to enjoy a further rally. In our base case, the Bank of England will have no need for any type of marginal hawkishness in the foreseeable future, and no exceptional growth boom will make sterling assets unusually attractive for investors.
House view: As a result, we do not believe 2021 will see a return to “pre-Brexit” exchange rates against the dollar, euro, or on a broad basis.
Consistent with these views, we revise our GBPUSD forecasts to 1.24, 1.29, 1.34, and 1.36 for 2020 Q3 and Q4, and 2021 Q1 and Q2 respectively.
Chart: Sterling underperforms G10 currencies in 2020
Relative volatility & sterling-euro
The Financial Times recently ran an article arguing the pound has become an “emerging market” currency, quoting a large US bank. We reject this characterization. Although sterling did go through a major regime change in volatility after the 2016 EU referendum, we argue it has simply joined its peers as a floating currency attached to a small open economy, although a relatively large economy within that category. Laying aside obvious realities such as per capita income levels, and central bank credibility, a simple visual inspection of monthly historical volatility is instructive. Historical 1-month realized volatility was below the G10 average more often than not prior to the Brexit referendum. Following the referendum, volatility levels were broadly in line with the G10 average, with some periods of higher volatility. Regardless, historical volatility in sterling remains well below classic EM currencies.
Chart: EU referendum was a regime change for GBP volatility – EM basket includes MXN, BRL, RUB, ZAR, IND, IDR
Sterling’s returns over the next 6 and 12 months are, in our view, likely to be broadly comparable with other small, developed open economies. Over the 6 month horizon, we believe ongoing Brexit uncertainty and a severe domestic coronavirus situation are likely to drag somewhat on sterling’s rally against the dollar. Over the 6-12 month horizon, as Brexit risk is removed following the signing of a trade deal with the EU, we believe sterling will enjoy a modest bump that will make it one of the better performing G10 currencies. As always, quantifying the size of this bump is difficult and a matter of subjective judgement. Purchasing power parity studies and pre-Brexit historical trading ranges suggest a level for GBPUSD closer to 1.60. However, the risk of sluggish productivity growth, a likely regime change in how markets trade sterling in general, and lasting consequences from Brexit all suggest to us that such levels will remain elusive to the pound over the next year.
Against the euro, our expectations for muted sterling performance over the next 6 months, combined with a modest bump for the euro on fiscal breakthroughs, mean we believe the pair is likely to see a modest rally to around 1.13 by the end of the year. Into 2020, our assumptions about sterling imply a further rally in GBPEUR, towards but below the 1.20 area.
Chart: Brexit has dealt a lasting blow to GBPEUR
The recovery has begun, but from a very low base
Like most major economies, the UK experienced an historic negative shock to output and employment in Q2, but will continue to recover as lockdown measures are eased and stimulus takes effect. The pace and extent of this recovery remains highly uncertain and contingent upon economic restrictions not being re-imposed. Assessing the short and medium-term UK economic outlook is less straightforward than in many peer economies.
In addition to the effects of the covid-19 pandemic, in the short-term assumptions must be made about new trading relations with the EU. In the longer run, the impact of Brexit on productivity growth must also be examined. High frequency data suggest that the initial shock to the economy from covid-19 lockdown measures has been less severe than expected by the Bank of England in May’s Monetary Policy Report.
We think UK growth is likely to total around-10% this year, and broadly agree with the BoE’s assumption that the loss of output associated with covid-19 will be recovered at some point in 2021.
Nonetheless, output has fallen by a historic cumulative 25% across March and April. In May and June the economy gradually began to re-open, and high frequency data supports the idea that this has resulted in an end to the covid induced contraction. Payments data such as CHAPS points to an increase in overall consumer spending as early as May, while surveys from private providers such as Markit, the CBI as well as BoE Agents reports and Decision Maker Panels all point towards a roughly 20% quarter on quarter fall in GDP from Q1 to Q2. The June flash reading for the Composite PMI was below 50 for the UK, which would normally point towards a fall in output. However, we believe the Markit PMI surveys should be viewed as sentiment indices as opposed to diffusion indices in the current circumstances of high uncertainty among businesses. For example, in the aftermath of the 2016 referendum the indices greatly overstated the actual fall in output. Treating the indices as sentiment indicators for now suggests the rapid rise between the May and June readings should be taken as an indication that on the whole the economy is returning to growth.
Chart: UK GDP chained at market prices – 25% cumulative March-April fall indicted. The BoE’s “illustrative scenario” from the May MPR expected this output loss to be recovered by 2021 – a far faster recovery than from the 2008 global financial crisis.
How quickly will the UK bounce back?
Beyond the immediate term, we believe the UK economy is likely to recover the 25% peak to trough output decline over the next 24 months – the question is what pace the recovery will take. In the second half of 2020, this will depend on two factors.
Firstly, the extent to which social distancing restrictions remain in place and therefore weigh on economic activity. Secondly, persistence of the shock to consumer and business behavior. Small changes in assumptions about either of these two drivers have the potential to significantly derail any central forecast of the UK economy. For this reason, the Bank of England re-branded the forecasts in the May Monetary Policy Report an “illustrative scenario”. The scenario envisaged a relatively rapid recovery in growth, based on the assumption that covid-19 restrictions are eased gradually and removed by the end of Q3. The MPC assumes a drag on consumer and business confidence that lasts beyond the end of lockdown measures – but in its scenario, monetary and fiscal stimulus are enough to counteract this effect and see GDP reach its pre-shock level in 2021. The IMF seems to have made more pessimistic assumptions in its June 2020 forecasts, which were conditioned on “greater scarring” from a larger than anticipated hit to activity and negative productivity effects from new safety standards in businesses.
As of writing, our view is broadly in line with the IMF and private sector forecasts that the shock in 2020 will not be as severe as the -14% forecast by the BoE. Judging both the path of re-opening and the rate at which consumer and business sentiment recovers is a matter of balancing multiple sources of uncertainty against each other. As discussed, high-frequency data suggest economic activity has begun to pick up at a faster than expected rate due to lockdown measures easing. Initial data from the housing market also suggest that consumers remain very willing to purchase properties: Zoopla data shows the number of agreed sales is running 4% above pre-crisis levels, while the website’s measure of demand is 46% above March.
These positive indicators must be weighed against overall uncertainty in the labour market outlook, as well as the risk of localized re-imposition of lockdown measures, of the sort recently seen in Leicester. The effects of the lockdown on labour markets remains to be seen, but the above anecdotal evidence supports the idea that consumer sentiment may be surprisingly resilient.
Consumer resilience was a development that caught forecasters off-guard in the aftermath of the EU referendum. The effectiveness of the Government’s coronavirus job retention scheme may be another support for consumer behavior. However, with the scheme due to be wound down and some surveys suggesting significant amounts of furloughed workers will be made redundant, the development of the labour market and consumer behavior remains a key source of uncertainty. Equally, the geographical extent and duration of regional lockdown measures is another key downside risk that remains difficult to predict and even more difficult to quantify. If lockdowns of the sort imposed in Leicester become widespread, or last beyond Q3, the base case forecasts from institutions for 2020 or even 2021 will be severely affected.
A barebones free trade agreement by 2021
Beyond 2020, assumptions must be made about two key factors. Firstly, if the UK and EU will transition to new trading arrangements based around some form of free trade agreement smoothly at the beginning of 2021, and secondly the long run impact of those arrangements on productivity growth.
Our position on the ultimate outcome of UK-EU trade talks remains unchanged: we believe that some form of free trade agreement covering some or most goods will be reached, although provisions for services trade will be extremely limited or non-existent.
The EU’s long-standing goods surplus with the UK is a natural incentive to do a deal in this area, and recent rhetoric from both sides has been conciliatory. Although “level playing field” provisions remain a major sticking point, there are plausible mechanisms for resolving mutual standards agreements that seem to be within the stated tolerance of both sides – for example a tribunal for joint standards that defers to ECJ interpretations for EU law.
The question of long-run productivity effects is more interesting…
Academic literature on free trade agreements generally finds a positive effect on long-run productivity growth, and so long-run forecasts of UK growth of the sort produced by the Office for Budgetary Responsibility account for a productivity loss from leaving the EU. The OBR, for example, assumed in March that around 1/3 of the productivity loss due to Brexit had already occurred. We take no view on productivity growth in the long run; but note that it has been exceptionally difficult to forecast in the post-crisis period. It is possible that the productivity loss from Brexit turns out to be understated, or that new trade agreements or changes in the nature of global trade make Brexit less relevant as a productivity drag. The exact nature of the UK’s new trading arrangements with the EU and other nations will therefore represent an important additional factor for the longer-run outlook for the UK economy.
Bank of England to avoid negative rates
Recent BoE communication has suggested that the MPC is encouraged by incoming high-frequency data from the UK economy, and is aiming to avoid further large-scale monetary easing. The most recent MPC meeting saw the Committee promise to purchase £100bn of assets by around the end of the year. This represents a decrease from the previous rate of purchases, which saw the £200bn in QE announced in March all but completed by June. However, in both absolute terms and as a percentage of GDP, the sustained asset purchases are significant and mean that BoE easing will not be hawkish relative to any G10 central bank. In our base case, with UK growth recovering fairly rapidly in Q3 and Q4 amid a gradual easing of restrictions, the BoE will be able to avoid expanding asset purchases or implementing negative interest rates.
In addition to the most recent meeting minutes, two recent major communications efforts from senior MPC members suggest the BoE is “on hold” and will seek to avoid major easing:
- Writing in an opinion editorial for Bloomberg, Governor Andrew Bailey said the current level of central bank reserves should not be taken for granted, or “become a permanent feature”. The MPC’s front-loaded strategy with QE supports this view: although the Committee enacted an extraordinarily aggressive asset purchase program from March to June, the reduced pace of purchases is likely to keep the balance sheet as a percentage of GDP below several other central banks such as the Federal Reserve and European Central Bank.
- Chief Economist Andy Haldane voted against the latest expansion in asset purchases, and explained in a speech that the smaller-than-expected shock in Q2 means that according to current assumptions, the output gap would be closed at a rate fast enough to threaten the BoE’s goal of stable inflation at around 2%.
- We note, however, that to date during the post-2009 period no major central bank has managed a sustained fall in its balance sheet. Furthermore, should the economy fail to meet the BoE’s very optimistic expectations about Q3 and Q4 the MPC is likely to respond with further asset purchases, in preference to negative interest rates.