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Shot in the dark

14 Oct 2016 By Swaha Pattanaik

Currency strategists can be divided even when they agree. Forecasts for where the pound will be trading against the dollar in 12 months’ time ranged from $1.05 to $1.47 in a Reuters poll published on Oct 6. Even after a flash crash on Oct. 7, it’s fair to say that most pound-watchers expect it to fall further over the coming months. A spat between UK retailer Tesco and supplier Unilever on who takes the hit from a weaker currency suggests businesses too are starting to prepare for sterling to be lower for longer.

Clever economic models sometimes underpin such predictions. But even the most complex ones will struggle this time round. Britain’s currency is more in the thrall of politics than economics.

Why is sterling so tricky to forecast?

The usual rules for making long-range FX forecasts are more or less in abeyance when it comes to the pound. Economists often try to parse variables such as economic activity, inflation, trade and fiscal positions to decide where currencies will go. Yet those are all muddied by huge uncertainty about how Britain will handle its exit from the European Union and what sort of relationship it will have in the future with the bloc.

A so-called “hard” Brexit could reduce investment inflows into Britain. If it results in less trade, productivity might suffer in the long run. Yet economists have been wrong before. Few expected the British economy to prove quite so resilient in the months following June’s EU referendum.

The nature of these EU ties, and particularly the sort of access the UK will have to the single market, are up in the air and depend not on economic rationality but on haggling. Election timetables may have more influence on the outcome than what’s in the best economic interests of all sides.

So economics don’t matter?

In one sense, they don’t. Traders are less fixated on whether any particular piece of economic data is stronger or weaker than they expected, and more on how much Prime Minister Theresa May is willing to sacrifice in order to reduce migration into Britain. The more hardline her stance, the more intransigent they expect other EU countries to be about giving the UK free access to the single market. European Council President Donald Tusk warned on Oct. 13 that Britain can’t have its cake and eat it.

But in another sense, it’s all about economics. The only reason FX dealers – and by implication, currency forecasters – care so much about the political machinations is because they will determine how the British economy will perform in the long run, let alone in one or two years’ time. Each comment from a politician triggers a recalibration of economic probabilities.

Why forecast at all?

Many currency strategists would rather not predict where currencies will be trading in a year’s time. Yet most are obliged to do so. One reason is that exchange rates are often just one input into a much bigger decision-making process for many companies and investors. They need a base scenario for mid-term planning and one number is far easier to process than complex scenarios involving a slew of probabilities. The risk is that numbers subject to significant change and subjectivity are feeding into models on which businesses make long-term decisions.

Don’t markets offer some clues?

Derivatives prices can be a useful guide to future market conditions. For instance, options which expire after the end of March 2017 have become pricier since Prime Minister Theresa May said she would trigger the process to leave the EU by this date. This reflects expectations that sterling will be prone to bigger gyrations once negotiations actually get under way. For example, six-month implied volatilities have climbed to 11.95 percent from 10.1 percent at the end of September.

While this says nothing about whether investors expect sterling to rise or fall, another measure – known as the risk reversal – does. This second gauge shows investors’ preference to sell rather than buy pounds is growing.

Ok. So in sum, the pound will go…

Down, most likely. How far and how fast depends mainly on the Brexit newsflow, but not entirely. The U.S. presidential elections could take the driving seat later this year when it comes to the pound’s exchange rate against the dollar. What happens to the U.S., euro zone or Japanese economies and how central banks react will also influence sterling’s exchange rate against the currencies of these countries. Where those currencies go is equally open to debate. In sterling’s case, the downward direction of travel is not in much doubt.


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