Sterling’s place in the FX space

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While we’ve suggested a benign outlook for GBP, what matters for currencies is how they compare to others. We see GBP as one of the better positioned currencies in the G10 FX space.

Would a weaker GBP help the UK economy? 5 of 5 Valuation: not much downside left 3 of 5

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EUR/GBP: Sterling to marginally outperform EUR
We expect GBP to strengthen against EUR. While both the UK and the euro area are showing signs of recovery (euro area GDP grew in Q2 following six consecutive quarters of contraction), the UK’s recovery should be stronger.

Furthermore, given below-target euro inflation and a passive tightening of euro area monetary conditions (as euro area banks repay long-term refinancing operation funds – LTROs), we see scope for the ECB to embark on further easing measures, possibly including interest rate cuts or very long-term TROs. Hence, the monetary outlook appears to be marginally favourable for GBP. We expect EUR/GBP to move closer to 0.84 and 0.83 over the quarters ahead.

GBP/USD: USD still looks better
Despite our constructive view on GBP, we expect it to modestly decline against USD, due to more favourable US economic and monetary prospects. The US economy should cyclically outperform the UK, while improving US labour market data suggests that the Fed’s exit from its ultra-loose monetary stance is closer. With the unemployment rate close to the 7% “end-of-QE” threshold, we expect the Fed to announce QE tapering in September. While rate hikes are still some way off, we suspect the Fed will be the first major central bank to increase interest rates (its forward guidance is no less fallible than the BoE’s). This – coupled with our longstanding view that USD is now more pro-cyclical
– suggests that USD should outperform GBP. We expect GBP/USD to trade around the 1.50 level in 6-12 months.

Sterling’s valuation is well positioned against CHF, AUD and selected EM currencies

Long GBP, short CHF and AUD
Although we expect GBP to weaken against USD and strengthen against EUR, movements are likely to be modest. We prefer expressing our (constructive) view on GBP against CHF.

We believe it is only a matter of time before CHF weakness unfolds because of its expensive valuation and/or a reversal of defensive flows. This, coupled with the floor under EUR/CHF, makes long GBP/CHF positions attractive. That said, we see even more value in being long USD/CHF, which remains our highest conviction trade.

We also find long GBP/AUD positions attractive. Despite AUD’s collapse in May/June this year, we expect further AUD weakness. Not only do Australia’s fundamentals remain weak (see June Compass), the Fed’s tapering of QE should exert downward pressure on high-yielding currencies, such as AUD.

EM to struggle against GBP
We expect GBP to do well against most emerging market currencies in September, as news flow surrounding QE tapering intensifies. In this environment, EM currencies with external funding needs (i.e. current account deficits, net foreign liabilities) are likely to be under pressure. INR, IDR, TRY, ZAR and BRL all look vulnerable against GBP.