Barclays believes the pound is undervalued at its current level, and projects that the single currency will push higher against the euro by the start of 2017.
On August 19, Sterling was on track to close its fourth weekly loss against the euro. Since May, the pound only pushed higher against the euro in two out of 11 weeks. Momentum may not be in favor of the pound, but other factors may push the currency ahead, according to analysts at Barclays.
After the Bank of England (BoE) announced an easing package that was larger than expected in early August, the pound declined to about 10% below its pre-Brexit level, analysts say. This also happens to be 10% lower than the estimated fair value of the British Pound.
Lloyds Bank’s IFO report for August observed a similar undervaluation.
One thing both banks can agree on is that the pound’s undervaluation is likely due in part to political uncertainty in Britain following the referendum vote to leave the European Union. Barclays says political risk accounts for about 3.2% of the currency’s 10% undervaluation.
The UK’s heavy reliance on imports is also putting downward pressure on sterling. Britain imports more goods than it exports, so it’s heavily reliant on foreign investor flows.
The referendum sparked fears that uncertainty will cause foreign investor flows to dry up. But the current deficit, some analysts suggest, would actually see the pound being on par with the euro.
The Bank of England’s inflation report, however, said the pound’s weakness should be taken into account in providing a discount to foreign investors to maintain financing for Britain’s account deficit.
So long as the pound is lower, capital inflows will continue.
Barclays does agree with this viewpoint – a weaker currency will help balance the deficit to a certain degree.
But Hamish Pepper at Barclays believes further weakness in sterling is unnecessary and forecasts a 7% appreciation in exchange rate by the end of the year despite political and economic uncertainty.
Barclays also believes the Bank of England has room for additional monetary stimulus, but such a move is unlikely to weigh on the currency. Pepper forecasts the GBP seeing gains against the euro in the coming year.
The euro, on the other hand, is likely to struggle going into 2017. Barclays believes the euro’s risk premium should be higher due to increased financial and political risks in the Eurozone. The European Central Bank also has little room for more monetary stimulus compared to the BoE.
Pepper projects that EUR/GBP will hit 0.78 by the end of the year, or GBP/EUR of 1.28.
At this point in time, the economic impact of the referendum is still unknown, but initial data appears to be better than expected. Suggestions that the U.K. would be moving into a recession in the second half of the year seem overly pessimistic at this point.
While there is certainly room for the pound to gain against the euro, it’s important to keep in mind that sterling is still vulnerable. Some analysts say it’s still too soon to say the pound has bottomed out.
The biggest issue, analysts say, is the sharp decline in PMI surveys for non-manufacturing and manufacturing surveys. Both reached fresh lows, which suggests further easing may be needed in the near future.
Source: Pound Sterling Live