Brexit negotiations have the potential to be a huge disruptive force and a continued source of volatility for GBP in 2018.
While the UK Prime Minister Theresa May has been successful in moving the Brexit negotiations with the EU on a key issue of trade by the end of 2017, there was plenty of Brexit related events that have undermined her political leadership during last year including a failure of the Conservative party to gain a decisive victory in snap parliamentary elections in June 2017.
On the economic side of the story, the GBP is expected to suffer due to widening growth differentials between the US and the UK. The gap in the economic growth rates also widens between the UK and the Eurozone.
In terms of monetary policy, there are plenty of reasons for the Bank of England to stay pat on interest rates including the inflation rate peaking at 3.1% y/y in November of 2017 while the GDP growth suffers from negative real, inflation-adjusted wage growth that weighs on consumer spending and tight UK labor market. On the other side of the Atlantic, the Federal Reserve is still widely expected to continue its monetary policy normalization raising policy rates at least three times in 2018 after it hiked rates three times in 2017.
Growth and interest rate differentials favor US Dollar
The growth and the interest rate differentials are key reasons for investors to handle Sterling against the US Dollar carefully in 2018. The US economic growth rate is likely to be boosted in a short-run by the tax reform that will lower the individual as well as corporate taxes in the US.
According to December economic projections from the Federal Reserve, the US GDP is expected to rise 2.5% in 2018 and 2019 while decelerating to 2.1% in 2019. The November Inflation Report from the Bank of England, on the other hand, saw expected GDP growth rate of 1.5% in 2018 picking up to 1.7% for both 2019 and 2020.
As for the policy outlook, December dot-plot from the Federal Reserve shows 3-4 interest rate increases pinned for 2018 while the Bank of England has made it clear while delivering extremely dovish rate hike in November 2017, that the path of the policy rates normalization will be very gradual with the extent of rate raises limited. That is pinned the Bank of England for a maximum of 2 rate hikes from now onwards until 2019, supporting the case of the US Dollar strengthening.
The GDP forecasts from Federal Reserve and the Bank of England
The Bank of England has already indicated in November Inflation Report press conference that the labor market slack has almost entirely been absorbed in the UK economy and that it is the labor market tightness that is the main driver of the economic growth.
Other segments are under pressure with the post-Brexit Sterling depreciation lifting inflation way above the Bank of England inflation target as well as bringing real wages into negative growth rate territory weighing on consumer spending.
The UK exports are boosted by either Sterling’s depreciation and rising demand, especially from the countries of Eurozone, but it is still not enough to take over lower household consumption.
The UK Prime Minister Theresa May announced in April 2017 that there will be snap elections held in the UK on June 9, 2017. The reason was simple. May planned to strengthen her position after officially triggering Brexit procedure with the EU on March 29, 2017.
The election results were a failure for Theresa May and her Conservative party. Tories managed to win the elections but lost 13 members of the UK parliament gaining 316 seats. The Labour party was the unexpected winner gaining 259 seats in parliament, 30 more than in the previous elections in 2015.
The Conservative party was forced to form a minority government with the support of Northern Ireland’s Unionist party.
A weaker position of the UK Prime Minister reappeared several times during the course of the year 2017 with either member of her own Conservative party revolting while voting against the laws proposed by the Conservative party in parliament, or Brexit hardliners like Foreign Secretary Boris Johnson and Michael Gove standing in fierce opposition in some Brexit related topics.
The key issue for 2018 for the UK economy and for the GBP/USD will be the ability of the UK government to get a trade deal in what seems to be a very complicated issue of Brexit negotiations.
Long-term technical picture
Sterling managed to recover from post Brexit lows of below $1.2000 against the US Dollar with a general trend of GBP/USD during 2017 being consolidation higher.
From the beginning of the year until September, Sterling gained as much as 14% against the US Dollar jumping off the low of $1.1988 as high as $1.3658 in September. Since peaking on September 19, 2017, the sideways trend prevailed with GBP/USD trading within $1.3020-$1.3550.
Long-term oscillators favor sideways trend to extend into 2018 with bias rather negative. Both Momentum and Relative Strength Index are positive territories, with Momentum pointing downwards. The most important feature though is the crossover of signal lines in Slow Stochastics that indicate corrective move lower. The sideways correction lower on GBP/USD should face several important hurdles including 38.2%-50%-61.8% Fibonacci retracement at $1.3030-$1.2830-$1.2630.
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