As the pound resumes its post-flash-crash, post-May-Brexit-debate bounce, Goldman's Silvia Ardagna warns of much more downside pressure to come for Sterling with a cumulative depreciation of as much as 25% by year-end.
How Much More Sterling Downside? (via Goldman Sachs)
1. With the prospect of a 'hard Brexit' becoming a reality, investors who were previously expecting a 'soft' Brexit, or no Brexit at all, have updated their priors, and Sterling has depreciated about 5 percent over the space of a week against G10 currencies. GBP/$ is about 1.5 percent above 1.20, which is our 3-months forecast published on 5 July 2016. In a recent Global Markets Daily ("How Much Sterling Downside?, 6 Oct 2016), we highlighted that risks to our Sterling forecast were to the downside. In this FX Views, we quantify the magnitude of a potential further fall in the Pound. Based on our benchmark model that assesses the impact of political uncertainty on currencies, the cumulative depreciation of Cable could be as large as 25 percent by year-end, an additional 7 percent decline from its current value.
2. While this estimate is subject to the usual degree of model uncertainty (see below) and should be viewed with a degree of caution, the following additional considerations lead us to think that such a downside move in Sterling is quite likely to materialize over the next couple of months.
First, while difficulties and hostilities around the process of negotiating Brexit have come to the forefront in the past week, in our view, the negative news has not yet been fully reflected in FX.
Second, we expect data to deteriorate over the next year, surprising more to the downside than it has done so far, also weighing negatively on the currency.
Third, we expect that monetary and fiscal policy will continue to place more weight on economic activity than on inflation; hence, policy news will be at worst neutral and at best negative for the currency.
Fourth, the repricing of a policy rate hike in December by the Fed and the USD strength associated with it can also contribute to Cable downside.
Finally, at the current juncture, we continue to think that, despite the large current account deficit, the UK will not face a balance of payments crisis of the type seen in emerging markets. A sudden stop of capital inflows forcing a much larger devaluation of the currency is unlikely, as long as the UK's rule of law and institutions remain stable and business friendly. That said, even without a balance of payments crisis, we show below (Exhibit 3) that there have been eight episodes in the UK where the currency depreciated by 25 percent or more over a period of less than a year, even though in many of these cases the exchange rate regime was either fixed or pegged, and the UK government either moved to a flexible regime or announced a one-off devaluation.
3. Elevated uncertainty translates into sizeable currency weakness. The UK vote to leave the European Union has led to a sizeable increase in political and economic uncertainty. The UK uncertainty index constructed by economists Baker, Bloom and Davis doubled from May 2016 to July 2016: this increase was about 30 percent larger than that observed in the aftermath of Lehman and the index remains at a high level compared with its long-run average.
Historically, periods of substantial currency weakness have been associated with a rise in economic and political uncertainty, and around episodes of large devaluations the increase in uncertainty also seems to lead the currency.
In past research, we have used a vector autoregressive model to estimate the potential impact of Brexit on Sterling. Now that we can measure the actual increase in uncertainty since the Brexit vote, our updated model shows that an increase in uncertainty of the same magnitude as that observed in the aftermath of the UK vote to leave the European Union translates into a sizeable depreciation of the currency.
Over the six months from the occurrence of the shock, the model predicts a cumulative depreciation of Cable of around 25 percent, which is about 7 percent more than the downside move in Cable that has already occurred. Interestingly, the magnitude of the total change would be similar in size to that observed from peak to trough after the Lehman collapse. However, as Exhibit 5 shows, the model has underestimated the amount of cumulative depreciation that occurred between June 2008 and March 2009, which suggests to us that there is more scope for downward surprise to our current 3-month Cable forecast of 1.20, particularly as we expect uncertainty to remain elevated for a longer period this time around.
4. Positioning is short but not an unduly large headwind to a weaker currency, in our view. GBP shorts have remained at stretched but stable levels since the referendum, and our Sentiment Index – which transforms net positioning (in contracts) into an index between 0 and 100 based on min and max positioning on a three-year rolling window – is at its minimum value. That said, in previous research we showed that stretched short positioning for GBP/$ has, on average, a momentum signal. Moreover, we think that long-term investors will still have to adjust their portfolios to incorporate the latest news around the UK government's decision to leave the European Union and the lack of sympathy from the European partners on the UK's demands on labour mobility.
5. Data expected to deteriorate and, since the referendum, UK nominal rates and Cable more sensitive to data surprises. With the exception of the initial sharp decline in the July PMIs, the majority of UK data has surprised on the upside since the Brexit referendum. That said, our economists forecast a sizeable business-investment-led slowdown over the next 12-18 months, and our analysis on the sensitivity of UK interest rates and Cable to data surprises suggests that these asset prices have become more sensitive to news, particularly on PMIs, since the referendum. This suggests that if we are right about the slowdown in economic activity, we should also anticipate a more sizeable response reflected in the currency. The risk is that in the near term the weaker currency boosts exports supporting economic activity.
6. Policy stance placing more weight on weak growth than on accelerating inflation is negative for the currency. The better-than-expected UK data has led the market to price out further cuts in the policy rate in coming months. However, our GBP view is not affected by whether or not the BoE decides to cut Bank Rate in November. First, the Bank of England has made clear that it does not believe it appropriate to push rates into negative territory, so the scope for interest rate cuts was limited in any case and a widening of the USD-GBP interest rate differential (the relevant metrics beyond our FX forecasts) will come from a higher policy rate in the US. Second, and importantly, what matters is the BoE's willingness to accommodate any fiscal expansion that the government may announce – our UK Economists expect the Bank of England to expand QE by an additional £50bn in 2017, and to continue to put more weight on the slowdown in economic activity than on the acceleration of inflation.
Some have asked us whether the Bank of England could increase interest rates to halt the decline in the currency. While in principle we cannot rule this out, we think the trade-off between inflation and activity does not justify such a move at this time. Based on our economists' forecast, inflation should peak at 2.3% in Q3 2018. Even accounting for some downside risk to our FX forecast, inflation should not increase much above the BoE's target as weak demand and the cut in VAT that our economists expect should moderate imported price inflation.
7. Despite the large current account deficit, we do not expect a sudden stop of capital to the UK. We do not expect the UK to face a sudden stop of capital inflows, as experienced by emerging market economies with large current account deficits. The UK's large current account deficit not only reflects the country's competitiveness position, but also the attractiveness of its assets. In fact, in recent years the trade deficit has remained broadly stable, while the income balance has deteriorated due to the high returns paid on foreign investment in the UK and the large capital inflows right after the European sovereign crisis. At least as long as the UK's rule of law and institutions remain stable and business friendly, capital should continue to flow to the UK in an orderly fashion. But, if we are wrong and the UK does face such a situation, given the low level of interest rates and high uncertainty over negotiations on trade agreements, it would take a significant change in the monetary policy stance to stop capital outflows. That would risk a very significant recession and a high cost for UK households, which are still heavily indebted and particularly exposed to short-term policy rates via mortgages.
8. Valuation models: not so useful at this juncture, in our view. Clients often ask us whether Sterling valuation makes a compelling case for Sterling upside from here. While our GSDEER model's fair value estimate for GBP/$ is 1.44, we think this fair value can be quite misleading as Brexit can turn out to be a structural break for the UK economy. Depending on how negotiations evolve, productivity and terms of trade for the UK can change quite significantly in the years ahead, and extrapolating long-run trends for these variables from past relationships could be challenging at this time. More useful to quantify the potential downside for Sterling are models that look at the relation between currencies and current account deficits. In coming publications we will explore this link and also look at how the economy and the currency evolved around the episodes of large Sterling depreciations listed in Exhibit 3 above.