GBP: Politics breaking the cycle – HSBC

GBP has been fixated on cyclical, rather than political or structural drivers and analysts at HSBC believe this will change as politics will come into clearer focus as time marches towards March 2019, when only one Brexit outcome will be possible. They further add that they believe the market is under-pricing the risk of a “no deal” Brexit and we see GBP-USD falling to 1.26

Key Quotes

“Cycling has become one of the most popular and fastest growing sports in the UK. But it is not just “middle-aged men in lycra” taking up two wheels. GBP has also been caught up in the cycling buzz – albeit in a slightly different manner. The pound has been pedalling along to cyclical drivers, while largely swerving political risks and ongoing structural frailties.”

“Admittedly, weaving political risk into a currency forecast is seldom easy. And it may be that the road to Brexit is so long, winding and uncertain that the market is unwilling or unable to express a coherent political view on the GBP. But we believe that ignoring political factors is a dangerous strategy.” 

“Politics is a vital cog, one the FX market has arguably downplayed in 2017, preferring the more visible and intuitive tracking of cyclical drivers. The cycle may have felt especially pertinent as the market countenances a shift in monetary policy stance to a tightening bias from a loosening one. But the sole focus on interest rate differentials is a mistake, in our view. We believe this has led to an overly optimistic consensus for GBP-USD, and a sizable descent for the pair in 2018.” 

“We believe the market will move through the gears and reconsider politics much more actively as the finish line for Article 50 negotiations looms into view. One way to remove the political blinkers is adopting a more straightforward view of a complicated situation. We coalesce the myriad Brexit outcomes into three, ranging from “soft Brexit” to “no deal”. Each carries different implications for GBP-USD, ranging from 1.45 down to 1.10 in our view. By attaching a probability to each outcome, a weighted exchange rate is generated. This helps inform whether one believes the spot FX market is under-pricing political risk or not. We believe it is.”

“In the end, we will finish with only one outcome. Our range of possible Brexits will condense to one. In this way, GBP will begin to behave like a European option with an expiry date of 29 March 2019. At this point, any prior forecast will immediately be shown to be in or out of the money. But until we reach this moment, GBP should be seen as the blend of different probabilities of each outcome alongside a blend drivers: political and structural, not just cyclical.”