British pound looks set to keep rallying

BY DEB SHAW | 

  • Regional growth in Europe and the UK remains strong, and provides a tailwind for GBP
  • Despite sentiment being fairly bullish, the pound remains below overbought thresholds
  • Looking at the last 30+ years, the currency remains historically cheap relative to other currencies

After a great performance in 2017, the good times for the British pound look set to continue. While manufacturing and construction PMIs announced earlier this week missed expectations, services PMIs beat optimistic expectations. Given the forward-looking nature of PMI surveys, upcoming GDP growth should remain strong. As services dominate the UK’s exports, this news was well-received in foreign exchange markets and the pound rose following the announcement. Looking onto the horizon, we believe the pound can continue rallying thanks to strong regional growth, moderate sentiment and the historically low value of the pound relative to other currencies.

 

High growth and low inflation bode well for GBP

The pound tends to appreciate during global economic booms. Looking back at history, the currency was strongest during the 2005-2007 pre-financial crisis era and during the 2013-2014 bull market. Given that the Eurozone is the UK’s biggest destination for services exports, the pound also tends to track the fortunes of the euro.

Thanks to strong growth in the Eurozone and accelerating manufacturing PMIs, regional growth is likely to remain strong. On the other hand, weak inflation is likely to limit any monetary policy response via higher interest rates. An overview of recent growth and inflation in the Eurozone is shown below for reference:

Accelerating growth, low inflation = bull market

1-4-2018 EZ GDP
Source: Eurostat, note Q4 2017 CPI based on estimate of 1.5% for December

 

Pound sentiment is bullish, but not at dangerous levels

Looking at trader sentiment, the last time GBP/USD surpassed 1.35 (in early December 2017) the pound was looking overbought. We made this judgement based on both technical indicators and looking at speculator net positions on US futures exchanges. At the time, we wrote that the short-term optimism behind the pound was looking stretched. GBP/USD weakened shortly after we published our thoughts. Funnily enough, the pound was also looking overbought in late September 2017 when GBP/USD was also above 1.35. After we wrote that the pound was susceptible to a pullback at the time, the currency soon weakened.

This time, and despite GBP/USD trading above 1.35, the pound remains out of the danger zone. Looking at technical indicators such as the Relative Strength Index, the currency continues to trade within a normal range. Looking at recent data based on net speculator positions on futures exchanges, positions are not at bullish extremes. While sentiment is clearly bullish, the pound remains out of the danger zone. Thus the currency has room to keep rallying without running into significant resistance.

 

Brexit fears keeps pound undervalued

Given the political nature of the Brexit negotiations, there is significant uncertainty regarding the future. As such, many investors are hesitant to hold the pound given the risk of a “no deal” scenario. If the UK exits the European Union without a trade deal, the disruption to its economy (which is deeply intertwined with the region) would be significant. Until there is further clarity on the future trading relationship between the EU and the UK, uncertainty is likely to keep the pound subdued.

An overview of nominal effective exchange rates since 1984 are shown below. As can be seen in the chart, the pound has seldom been cheaper relative to other currencies even after its strong performance in 2017. As described above, the pound remains cheap due to the perceived risk of the ongoing negotiations.

Pound remains on sale

1-4-2018 GBP NEER
Source: Bank for International Settlements

 

All in all, the ongoing economic upswing, reasonable sentiment and low valuation of the pound (thanks to Brexit) are good reasons for the currency to keep rallying. Given the political nature of the trade negotiations, the exchange rate is likely to remain fairly volatile. This being said, the long-term trend behind the currency is bullish.    

Topics: British pound

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