Pound-for-pound, sterling still quite cheap

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On 14 July I made the case for a bullish GBP/EUR view, premised on concerns about the Greek bailout’s medium-term viability and an overly dovish market pricing of Bank of England rate hikes. Since then sterling has appreciated 1.7% versus the euro, with GBP/EUR at its highest level since November 2007, but I remain conservatively bullish.

Greek deal: Near-term stop-gap, long-term challenges

The risk of implementation slippage in the Greek deal remains high particularly given the parlous state of the Greek economy. This is likely to keep the euro on the back foot, in my view, even if the ECB’s quantitative easing program manages to imminent contagion to other eurozone bond markets.

Slowly and painfully the elements are falling in place for the Greek government to obtain a third package of loans worth €86bn in exchange for implementing a long-list of fiscal measures and reforms (see Figure 1). But both sides have been surprisingly candid in their admissions that the current deal, which does not include debt forgiveness, will be difficult to implement and is unlikely to put Greece’s economy on a sound footing (see Figure 2). This ties in with the results of a recent survey I conducted in which 63% of respondents thought Greece would still have the euro in three months time, but only 35% thought this would be the case in three years.

Figure 1: Steps in the right direction…

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Figure 2: …but without debt forgiveness, Greece remains on very shaky grounds

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Central bankers say a lot, reveal little, but nudge UK markets

Central bankers on both sides of the Atlantic have made a lot of noise in the past 72 hours (see Figure 3). While Fed Chairperson Yellen and in particular Bank of England (BoE) Governor Carney did not actually reveal much, markets have halved the expected time lag between the US Fed and Bank of England starting to hike rates from around six to three months. This is in line with my expectation that while the Fed is likely to start hiking its policy rate first, the BoE is unlikely to be far behind.

Figure 3: You say it best when you don’t say very much at all

olivier desbarresSource: Federal Reserve, BBC

 

The market, which only a few days ago was pricing the BoE to start hiking its 0.5% policy rate in Q2 2016, has brought its expected launch date to Q1 2016. This is broadly in line with the results of a survey I conducted in late-May, in which respondents on average forecast the first hike in Q1 2016 – albeit with a quite a wide distribution around that central prediction (see Survey: Fed to lead BoE into slow and gradual rate hikes). Some analysts are even now predicting the hiking cycle to begin at the 5th November policy meeting, when the Monetary Policy Council will also release its quarterly inflation report (see Figure 4).

 

Figure 4: Future policy meetings for key central banks (date in brackets)

Olivier Desbarres - Pound for pound 4

Source: national central bank websites;  Note: RBA and BoJ have not yet released their meeting calendars for 2016.

 

At the same time, market pricing for the start-date of Fed hikes has been pretty static, with a 30% probability of a 25bp hike priced in at the 17th September meeting and a 60% probability of a hike priced by end-year.

There is admittedly a risk that markets now swing too far in favour of an early BoE hike. After all the same day that Governor Carney spoke to the Treasury Committee, June CPI data were released and revealed a fall in year-on-year headline inflation to 0.0% from 0.1% in May and in core inflation to 0.8% from 0.9%. Moreover, improvements in the labour markets seemingly stalled in May, with real earnings growth slowing and the unemployment rate ticking up albeit from a low base of 5.5% (see Figure 5). But similarly, the risk is tilted in my view towards the market also having to once again push out its expected start date for the Fed hiking cycle. US data have been blowing hot and cold, as retail sales show for example (see Figure 6).

 

Figure 5: Improvements in UK labour market stalled in May Figure 6: US retail sales fell in June after three consecutive monthly increases
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Source: www.olivierdesbarres.co.uk, UK Office for National Statistics (ONS) Note: Defined as seasonally adjusted weekly pay (regular pay plus bonuses) deflated by the Retail Price Index     Source:  www.olivierdesbarres.co.uk , US Census

 

Valuation – Headroom for further (modest) sterling appreciation

An argument against further sterling appreciation is that it is already rich or over-valued. Indeed sterling has appreciated sharply against the basket of currencies of its main trading partners, with its nominal effective exchange rate (NEER) at seven year highs (see Figure 7).

But the sterling NEER is still about 13% below the all-time high reached in late January 2007. Furthermore, as Figure 8 shows, the bulk of this appreciation has been driven by sterling’s appreciation versus the euro, which has arguably been justified by relative UK-eurozone fundamentals. Against its other main trading partners’ currencies, which account for about half of the NEER, sterling has on average appreciated by only 2% per annum in the past five years.

Figure 7:  sterling NEER has appreciated 16.5% in past 2 years but is still 13% below all-time highs Figure 8:  Bulk of sterling’s appreciation has been against the euro
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Source: www.olivierdesbarres.co.uk, Bank of England     Source:  www.olivierdesbarres.co.uk , investing.com, BIS Note:  includes CAD, CHF, CNY, INR, KRW, SGD, TWD, USD, TRY, SEK, PLN, CZK, DKK, HUF (BIS weights)

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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