GBP Outlook

1-3 Month Outlook

Only the commodity currencies underperformed GBP in Q3, and EUR/GBP is 500pts (7%) higher than the July low. Various explanations have been put forward for GBP's underperformance, including growing concern on the funding of the UK's gaping current account deficit and the rising risk of EU exit. Both are legitimate concerns, but still see them as tail risks, rather than key drivers. In reality, GBP underperformance in Q3 was a much more "vanilla" story of rate spread dynamics. The greater mystery, then, is why rate spreads have moved so far against GBP, which seems completely at odds with central bank forward guidance. The reality is that the decline in UK rate spreads has been almost entirely "passive" in nature, rather than reflecting an "active" policy debate. The decline in yields since mid-July has been a global phenomenon and UK yields have declined more simply because rates (spot and more so forward) are not at the zero bound. In other words, the UK is a "high beta" market when global yields are falling in tandem. 

"We put recent GBP underperformance down to a temporary decoupling from domestic fundamentals as global factors have dominated and expect a recoupling in Q4 with GBP outperformance reasserting itself", says RBC Capital Markets.

6-12 Month Outlook

Trending higher Longer-term, there are two key risks for GBP - the UK's unsustainable current account deficit and the EU referendum, promised for end-2017 at the latest. Both are manageable, however, and the current account may actually strengthen the case for GBP outperformance. The UK's external deficit is largely a public sector phenomenon and this is still true, but is becoming less so as the household sector slips into deficit. As this happens, the policy prescription is slowly shifting to tighter monetary and fiscal policy rather than fiscal policy alone. As to the rising risk of UK EU exit, on the face of it, there are reasons to think GBP should carry a rising risk premium. This month's YouGov poll showed a small (2pt) balance in favour of voting yes to leaving the EU. In the longer term, the balance of opinion has almost always been in favour of staying in and it still is when pollsters add a qualification that the government recommends voting to stay.