G10 FX Weekly: Play the Ranges in GBP With a Bearish Bias

Summary

• UK economic fundamentals look challenging, especially relative to developed market peers.
• Expect this economic underperformance to weigh on the pound in 2023, leading it to lag its G10 counterparts.

Market Implications

• For GBP/USD, we favour selling any strength within the ~1.19/1.25 year-to-date (YTD) range.
• For EUR/GBP, the ~0.87/0.90 range has contained the currency pair in 2023, and we again see sterling weakness going forward.
• For GBP/CHF, the ~1.10/1.15 range been in place YTD. Any increase in geopolitical risk and/or broader market volatility will increase haven demand for the Swiss franc, with sterling particularly vulnerable.

Introduction

The pound has had a turbulent time since the Brexit referendum in 2016, with a plethora of political and economic drivers giving traders a bumpy ride.

Recent months have been spectacularly volatile for the currency. Sterling traded at a ~35-year low versus the US dollar in September after the ill-fated UK mini-budget brought forth by then-Prime Minister Liz Truss and her Chancellor Kwasi Kwarteng. Then it turned around, bouncing sharply against the greenback.

So far this year, the pound has traded in relatively tight ranges against its various G10 peers, and these ranges should broadly be respected in the coming weeks and months.

Nonetheless, given the negative fundamental macro backdrop in the UK, traders will probably be more comfortable selling any bounces in the pound rather than fading weakness.

The Bearish Case for GBP

The near-term prognosis for the UK economy is challenging, especially relative to its peers. This economic underperformance will lead to sterling underperformance.

The UK Economy as a Developed Market Laggard

The update to the International Monetary Fund’s World Economic Outlook published last month was telling. In it, the IMF cut the UK’s growth forecast for 2023, putting it well below its developed market peers.

And, while some may question the IMF predicting a 0.6% contraction of the UK economy this year, the chart above clearly shows the UK as a laggard.

Britain is the only economy in the G7 not to have recovered its pre-pandemic size. The Bank of England (BoE) expects that UK GDP will not return to the pre-Covid levels until 2026.

Brexit Matters

So we arrive at the proverbial elephant in the room, a material challenge unique to the UK – Brexit.

Arguably, the UK economy has not recovered to its pre-pandemic size primarily because of the drag on Britain from Brexit.

Overall trade has fallen relative to the size of the UK economy, with trade not bouncing back post pandemic as fast as in other major nations. Additionally, investment, which was weak before the Brexit vote, has stalled since the referendum.

The UK Office for Budget Responsibility (OBR) has argued that the new trading relationship with the EU will reduce long-run productivity by 4% relative to remaining in the EU. Both exports and imports will be around 15% lower in the long run than if the UK had remained in the EU.

In addition to its GDP outlook above, the BoE has voiced additional concerns and warnings about Brexit’s negative impact on the UK economy.

BoE deputy governor Ben Broadbent said earlier this month that hits to the UK economy from Brexit are appearing faster than expected, saying that ‘Brexit … has pulled down potential output in our country in our assessment for many years.’ He added that ‘we’ve not changed our estimate of the long run effects but we’ve brought some of them forward. We think probably they’re coming in faster than we first expected.’

In a similar vein, Broadbent’s BoE colleague Catherine Mann said that Brexit is exacerbating inflation in the UK and worsening the cost-of-living crisis. Following the shock of the pandemic and the war in Ukraine, Mann highlighted a UK-specific problem: ‘the UK has also been affected by a third type of shock which makes it unique: no other country chose to unilaterally impose trade barriers on its closest trading partners.’

A Look at Three GBP Pairs

How does the negative bias outlined above feed into specific sterling currency pairs? We’ll drill down into three pairs – GBP/USD, EUR/GBP and GBP/CHF, below.

GBP/USD

This year, sterling has traded roughly in a 1.19/1.25 range versus the dollar, after recovering from the ~35 year low seen in October following the badly received Truss/Kwarteng mini-budget.

GBP/USD, or ‘cable’ as it is known in wholesale markets, dropped from the higher end of this range following the BoE rate decision and press conference on 2 February to trade sideways near the middle of this range over the past week or so.

The 1.19/1.25 range should probably hold in the coming weeks, as markets recalibrate on new data releases on both sides of the Atlantic. Given the bearish prognosis, we would look to sell any rallies in cable, with any range breakout likely to favour the dollar.

EUR/GBP

A weaker pound versus the euro call was made by my Macro Hive colleague Henry Occleston last week, and his reasoning is compelling.

Henry argues that recent messaging from the BoE and European Central Bank (ECB) was nuanced in opposite directions – the BoE was more dovish than expected, while the ECB was more hawkish.

This means that interest rate differentials will be biased in favour of the euro over the pound, as the BoE will likely pause the current tightening cycle, while the ECB will probably hike rates 50bp next month, with further hikes thereafter.

The contrast in approaches from the central banks, leading to the interest rate differential dynamics above, should lead to further downside for the pound versus the euro. EUR/GBP has been in a ~0.87/0.90 range YTD, currently trading near the middle of the range. While it is likely that the 0.90 level should contain sterling weakness in the coming weeks, any breakout of the range will probably favour the euro. And, as with cable, we would fade any GBP strength within the range.

GBP/CHF

GBP/CHF has been included in this piece given the safe haven appeal of the Swiss franc.

Last year, when geopolitical and economic uncertainty combined to weigh on investor sentiment, the franc rallied sharply versus the pound.

Should these uncertainties, especially geopolitical ones, ratchet higher, sterling will be particularly vulnerable against the franc.

This year, GBP/CHF has kept to a ~1.10/1.15 range. As with cable and EUR/GBP, we expect this range to hold. Nonetheless, as in these pairs, we would fade sterling strength in GBP/CHF.

Conclusion

UK economic weakness, both present and expected, mean that the British pound will struggle for any material upside in the coming months. Economic underperformance will feed into currency weakness.

The recent IMF forecasts expect the UK economy to lag its developed market peers. The BoE also painted a rather bleak picture of the UK economy and its prospects going forward.

As such, we like to fade any sterling strength in the major GBP pairs. To be sure, recent ranges in cable, EUR/GBP and GBP/CHF will probably contain price action in the pairs. Within these ranges, however, we favour downside. And, if any breakouts in ranges do occur, a weaker pound will drive them.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)