FX Forecasts: We maintain our forecast for EUR/GBP of 0.71, 0.70 and 0.68 in 3, 6 and 12 months, which we adopted on December 7. This implies GBP/$ at 1.46, 1.43 and 1.40.
Motivation for Our FX View: Sterling appreciated notably for much of 2015 as activity remained strong relative to the Euro area. However, Sterling has weakened by around 8% on a trade-weighted basis since November. This recent decline comes as global growth worries have weighed most noticeably on rates in the UK, with the timing of rate hikes pushed back substantially. In addition, some signs of a ‘Brexit’ risk premium may be starting to appear. Our base case assumes the UK will remain in the EU and that cyclical strength should ultimately allow the BoE to hike rates sooner than markets are currently pricing and, as a result, we see GBP as stronger vs EUR over the next year, with GBP/$ slightly lower.
Monetary Policy and FX Framework: In the February 2014 Inflation Report, the MPC modified its forward guidance to place a broader focus on the outlook for inflation and spare capacity, while emphasising that increases in Bank Rate will be gradual and limited. More recent Inflation Reports have shown some increased willingness on the part of the BoE to look through transitory inflation developments owing to currency moves. Sterling operates under an entirely free float, although the BoE occasionally comments on exchange rate developments.
Growth/Inflation Outlook: We expect the UK economy to expand by 2.6% in 2016. Overall, our relatively optimistic outlook is driven by our expectation for ongoing support from the consumer. We anticipate a benign inflation picture, with core CPI rising only gradually and remaining below 2% until 2018Q4. Monetary Policy Forecast: We expect the first increase in Bank Rate in 2016Q4. Subsequently, we expect the pace of further hikes to be steeper than current market pricing. Given the BoE’s focus on the disinflationary impact of exchange rate strength, external shocks that affect Sterling – particularly US data and policy developments – are being transmitted to the UK curve.
Fiscal Policy Outlook: The government still plans to reduce the deficit gradually, albeit at a slower pace than initially projected. The deficit is expected to turn into a surplus in 2017-18, mostly due to spending cuts.
Balance of Payments Situation: We forecast a current account balance of -5.4% of GDP in 2015. Portfolio flows remain difficult to assess given the large cross-border flows linked to London as a financial centre.
Things to Watch: The impact of the cyclical acceleration on capital inflows remains a key factor, as well as financial spillovers from the Euro area. Over the next year, the UK’s in/out referendum on continued membership in the EU will likely be a key source of volatility.
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