UK: Gauging sterling downside - RBS

Research Team at RBS, think about potential GBP/USD deviation from medium term fair value as a way of guesstimating the scale of the risk premium now to be priced in, probably quickly.

Key Quotes

“We estimate that GBP/USD was trading close to ‘fair’ in the weeks leading up to the Referendum. We have written before about how a move to one standard deviation cheap to medium term fair value in the event of a ‘Leave’ vote could take Cable down to 1.25. If anything, given how supremely confident markets were of a ‘Remain’ outcome yesterday afternoon, then arguably the ‘shock’ of a Leave could be yet greater and we could conceivably see a move down to test 1.20.

GBP/USD has also been tightly correlated with the difference between UK and US 2y swap rates. Since the July 2014 peak in GBP/USD, each 10bp change in the UK/US 2y swap spread rate has corresponded to a 3 cents move in spot. Based on historical correlations alone, a cut in the UK base rate to zero (-50bp) over coming weeks could be consistent with a 15 to 20 cents decline in GBP/USD from yesterday’s close. In the low 1.20 we expect strategic buying interest over coming weeks, something that may see a recovery to the low to mid-1.30s.

EUR/GBP is trickier because of the uncertainty over how much more risk premium for the EUR global FX markets have to price in. However, it’s clear that EUR/GBP has been less sensitive than GBP/USD to Referendum related developments. In recent months, slope of the short sterling interest rate curve has tracked the exchange rate relatively tightening. A 130bp flattening in the short-sterling curve since last November has correlated with an 8 cent rise in EUR/GBP. Given our expectation of BoE rate cuts and then an extended period of unchanged rates for a considerable period, the short-end of the curve is expected to flatten. We thus see EUR/GBP rising into the mid-late 0.80s.

Additional pressure on the fragile Euro area recovery and increased political/economic uncertainty about the European Union, is expected to also weigh on the EUR given its position as a central pillar of regional policy. Hitherto, we have been anticipating the next move in EUR/USD higher to 1.17-1.20. On the reality of a UK Leave vote, we now see risks of EUR/USD lower to around 1.05 (1.25 GBP/USD and 0.88 EUR/GBP). Overnight developments re-enforce our bearish USD/JPY outlook. More broadly, our real rates theme is further validated, not only as US real rates fall in response to the UK’s exit, but as deeper deflation looms for Japan next week.”