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GBP 2021: The B-word
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Andrew Kositkun Foreign Exchange Head Trader
The British pound is on track to finish this year as one of the worst-performing G10 currencies against the U.S. dollar. The pound has lagged most of its G10 peers not only because uncertainty around the U.K.–EU trading relationship has dragged out until the last possible moment but also because the U.K. economy has absorbed one of the sharpest COVID-19-related drops in economic output of any major economy. Third-quarter GDP in the U.K. is 9.7% below where it was in the fourth quarter of 2019. The comparable declines in the euro area, the U.S. and Japan come in at 8%, 4% and 2%, respectively.
Looking ahead, the 2021 outlook for the pound will depend on the interaction between the realities of Brexit and the speed at and extent to which the U.K. economy can recover from the pandemic. Regarding Brexit, the two remaining choices are an ultra-hard Brexit, under which trade with the EU will be subject to World Trade Organization rules, or a narrow deal that is hard-Brexit lite, as it will likely exclude services. Markets currently expect a narrow deal in the next week or so, but the only definitive deadline is Dec. 31 when the transition period ends. Everything else is just guesswork.
Regarding the U.K.’s pandemic recovery, there is an argument that the U.K. underperformance makes it one of the biggest beneficiaries of a vaccine. There are certainly merits to this, as Bank of England Chief Economist Andy Haldane has admitted vaccine news has been “to the positive side” of the bank’s assumptions. Haldane also added that it’s “tough to know for sure” if he would have voted for the increase in asset purchases if he knew the vaccine news. However, Brexit drags to growth and a massive fiscal deficit still provide counterarguments. Keep in mind that fiscal spending in the UK this year was more than double the average in the developed market, making the fiscal picture a more pressing issue than in most countries.
One of the key arguments to a high pound on a Brexit deal is valuation. To this point, the pound is significantly lower than its long-run average, so it is at the weaker end of the spectrum. But weaker is not the same as cheap. Long-term averages can only be seen as an anchor for the exchange rate if longer-term fundamentals are also relatively stable. The reality is that the U.K. had transitioned from a relatively high-growth and high-yielding economy to a relatively low-growth and low-yielding one before the damage from the pandemic and shock from Brexit. The pound is certainly weak, but concluding that it is cheap simply based on long-term averages is not a straightforward proposition.
Further, it appears that markets are focused more on whether or not there is a deal than what that deal actually means. A similar dynamic was seen in the rally following the December 2019 election that ushered in a large Conservative majority that backtracked as soon as markets realized this all but guaranteed a harder Brexit. It is likely that markets will overshoot what was initially thought to be the exchange rate landing zone on a skinny deal, partially due to vaccine optimism, but it is also possible that markets will sell the pound after a bounded and short-lived relief rally as it realizes that a skinny deal is still a fundamentally bad development.
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
The U.S. Senate returns today, with the House returning on Wednesday, as much work remains to be done by Dec. 11 to avoid a government shutdown. Complicating the issue is the need for further fiscal stimulus and the arrival of Arizona Democratic Senator-elect Mark Kelly. His win will be certified today and move the balance of power in the Senate to 52-48 for the Republicans. While hopes are for a deal, it is possible that Congress will have to pass another continuing resolution to temporarily keep the government open.
Tomorrow, Dec. 1, represents the latest Brexit deadline, as U.K. officials say this is the “last week.” However, Brexit talks have seen deadlines moved on a regular basis, so another extension wouldn’t be a shock. As has always been the case, fishing remains a key topic of contention.
Expectations are building ahead of next week’s European Central Bank (ECB) meeting. In past comments, ECB President Christine Lagarde has all but promised further stimulus measures. With rates already negative, additional stimulus is most likely to come through additional asset purchases. New macroeconomic projections will also be released at this meeting.
European leaders continue to work toward approval of a long-term European budget by Dec. 7. Poland and Hungary continue to threaten a veto over rule-of-law issues, but ultimately, unanimous approval is expected. Nevertheless, this approval delay will push back the start of the recovery fund from its original start date.
OPEC+ ministers have been unable to agree on an extension to production cuts during talks over the weekend. Talks will resume today, with a three-month production cut extension being discussed; however, a shorter extension may be needed to get all members on board.
China’s PMI numbers came in better than expected, with manufacturing PMI coming in at 52.1 versus expectations for a 51.5 print and non-manufacturing PMI coming in at 56.4 versus expectations for a 56.0 print. On the monetary front, the People’s Bank of China added 200 billion yuan of midterm funding to its financial system in anticipation of a year-end cash crunch. On the geopolitical front, the U.S. is planning to add four Chinese companies, including chipmaker SMIC and oil giant CNOOC, to the list of firms blocked from American investment due to military ties.
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