The pound is sprinting towards the end of 2019 as the world’s best-performing major currency, yet there are still plenty of hurdles to continue the rally next year.
After a make-or-break week for markets with the UK election and the threat of more trade tariffs looming, people in the City of London were heard cheering in the early hours of Friday morning after Prime Minister Boris Johnson’s self-styled “glorious” victory and a phase-one deal between the US and China.
That reduces two of the big risks for investors, though Johnson will still have to negotiate his own Brexit trade agreement with the European Union. “In the short run, globally, it’s like everything that could go right went right – no one could have expected better holiday-season developments,” said Marc Chandler, chief market strategist at Bannockburn Global Forex.
“People were Brexit fatigued and so happy to get it over with.” The pound, which has been dragged down by Brexit risk, surged the most since 2017 after the election result, yet had halved its gains to trade above $1.33 by the end of London trading on Friday.
To meet the most bullish forecasts for a further leg-up to $1.40 or above from the likes of Morgan Stanley and HSBC Holdings Plc, investors will probably need to see improving economic data and progress in talks with Brussels.
Johnson’s emphatic victory puts the UK on course to leave the EU next month, after pro-Brexit voters in Labour’s former heartlands swung behind his party. He now has a deadline of December 2020 to agree a future trading relationship with the EU, and traders will start to price in that reality, Chandler said.
Many analysts think such a deadline is overoptimistic and will be subject to extensions, continuing some of the uncertainty that has weighed on UK assets. Traders will also be looking out for the post-election view from a new governor due at the Bank of England, which next meets on Thursday. Policy makers led by current governor Mark Carney are expected to hold rates steady, though in the wake of the election results, money markets pared the probability for an interest-rate cut by August to 40% from 50% beforehand.
That came as growth is expected to get a lift from pent-up investment demand and with the government having promised to end a decade of austerity and open up the spending taps. In options markets, bets on swings in the currency have slid, yet demand for put contracts to sell the pound still outweigh those for calls both in the short and longer term, showing investors are hedging their positions.
“The question remains how it all plays out from here,” said Axel Merk, President and Chief Investment Officer of Merk Investments. The outlook has divided analysts, even within the same bank.
While currency strategists at London-based HSBC see this as only the beginning of a rally for the pound on an improved economic outlook, its bond analysts are markedly more downbeat, predicting the BoE will have to lower interest rates by May as the economy slows.
For Alessio de Longis, a New York-based senior portfolio manager at Invesco Investment Solutions that oversees $1.2tn in assets, some further downward movement in the pound is to be expected given the sharp move higher. The currency has gained more than 3% against the dollar this month and more than 4.5% this year, putting it at the top of the pile for major world currencies.
Yet de Longis expects that any pound depreciation will prove just a small blip within a multi-year trend higher for the currency, which should lift it annually on average by about 7% to 8%. Capital inflows to the U.K and its assets, a pickup in global growth and sterling’s current 20% undervaluation versus the dollar are key reasons for his views.
The currency was around $1.50 before the 2016 Brexit referendum. “Pound strength will continue fundamentally for years to come,” said de Longis. “Capital inflows coming back to the UK now will support the pound. And it will benefit from a slowly changing tide in favor of non-US assets.”
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