Why Brexit looks to be the key driver for the pound in 2018

The pound has been, and will continue to be, particularly sensitive to Brexit-related developments.

At this stage, ‘sufficient progress’ has been made in the initial divorce proceedings with a financial settlement in the region of £35-40bn, no hard border between Northern Ireland and the Republic of Ireland and an agreement on EU citizens’ rights such that UK and EU attention can now shift towards trade negotiations.

Statements from Brexit Secretary David Davis suggest the UK will seek a ‘Canada plus plus’ deal. He later added that the UK intended to treat goods and services as inseparable during negotiations.

However, European Commission chief negotiator, Michel Barnier has already specified that there will be no ‘special’ treatment for the financial services sector.

If anything, recent comments from both sides are a taste of the headline risk we are exposed to and highlight how difficult the negotiations may prove to be. Interestingly, the BoE has announced that EU banks will be able to operate broadly as they do currently, even in the event of a ‘no deal’.

Overall, while recent progress has reduced the chance of a disorderly Brexit, it remains a key risk for GBP, capable of triggering significant volatility.

Monetary policy

The evolution of BoE and ECB monetary policy stances will also play an important role in influencing the trajectory for GBP/EUR. Having raised interest rates by 25bps in November, the BoE is likely to take a wait-and-see approach, proceeding with caution.

The EQ Global Trading desk are forecasting the next increase in the UK Bank rate in August 2019. However, there are risks in both directions.

The current and expected levels of inflation could be used to argue for tighter monetary policy. Inflation in November came in at 3.1%, triggering a requirement for Governor Mark Carney to write a letter to the Chancellor of the Exchequer, Philip Hammond, explaining why this has happened and what action, if any, could follow. Moreover, the BoE’s own economic projections have inflation above target over the forecast period.

At the same time, the growth environment may be helped by maintaining policy at these loose levels. Some activity indicators suggest Q4 GDP growth may be slightly softer than Q3, and the health of the UK consumer is being carefully monitored.

With interest rate markets not fully ‘pricing in’ a hike until Q1 2019, uncertainty shrouds the Bank rate outlook.

The ECB has already announced its intention to reduce the size of its monthly asset purchase programme to €30bn until September. Beyond then, expect quantitative easing to be concluded by the end of the year and the first 10bp increase in interest rates in Q2 2019.

As widely expected, the Federal Reserve raised the Fed funds rate by 25bps at its December meeting. Policymakers continued on the path of normalising interest rates, against the backdrop of a tight labour market, reaffirming their ‘dot plot’ view for three further hikes in 2018. The EQ Global Trading desk agree and are also anticipating three US rate rises next year.

So what for GBP?

The recent signs of some positive progress with the Brexit process has helped GBP/USD up to the 1.35 region and GBP/EUR close to 1.13 as we start the year.

The theme for 2018 will be Brexit as the key driver for the pound and a high degree of volatility will continue throughout the year as negotiations continue.

Here are the EQ Global Trading Desk forecasts (Crystal Ball) for the coming four quarters:

 


 

This article first appeared on GTNews’ sister-publication bobsguide.

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