Executive Summary: we can expect 2017 to be a volatile year for the GBP/USD currency pair. There will be significantly more volatility in the first half of the year, compared to the second half, although politically motivated rate shocks will occur throughout the year. Outside of political shocks, we expect there to be an 80% chance of a December 2017 exchange rate of between $1.19 and $1.20. If the political shocks associated with Brexit go through as expected, this figure could be as low as between $1.07 and $1.13.
The ability to trade currency is key to the global economy. If a UK-based business exports goods or services to a USA-based consumer, then either the business will need to convert the USD paid back into GBP, or the consumer will need to buy GBP in order to pay the business. In order to facilitate this, currency is traded on the open financial markets. The rate at which they are traded is called the exchange rate and is decided primarily by supply and demand rules. Various factors decide on the supply and demand. The three main factors are:
- Pure economic factors such as GDP, interest rates and wage inflation: companies make investment decisions based on these factors which will either increase or decrease the demand of a specific currency. Ideas such as inflation and quantitative easing reflect the supply of the currency.
- Trade balances: As exports become greater than imports, the demand for a country's products, and therefore currency demand, becomes greater causing an upward pressure on the value of the currency. When compared with the trade balance of a different country, changes in trade balances can indicate if either currency will increase or decrease, changing the exchange rate.
- Political turmoil: The long-term stability of a currency is largely dependent on the economic factors and trade balances, but political turmoil may result in sudden short-term dramatic rate drops which can have a lasting effect on the price. These can either be unexpected shocks, such as the election of Donald Trump, or expected news which is finally confirmed such as the announcement of the UK leaving the EU by March 2017.
Since mid-2014, the GBP/USD exchange rate has been falling. This means that either the British pound has been getting weaker or the US dollar stronger. On July 15, 2014, the price of 1 GBP was $1.71. By October 7, 2016, however, the rate had fallen to $1.14. On January 27, 2017, the rate increased to $1.25. The chart below shows the price changes since January 27, 2016:
Figure 1: Graph showing rate changes in the GBP/USD currency pair: 27/01/2016 to 26/01/2017
The long-term rate tends to track against economic data - as various factors such as interest rates, inflation, GDP and trade balances change. The vast majority of currency trades are made for international business purposes, with a small percentage made by speculators attempting to buy currencies at one price, and later sell at a higher price. Due to this, economic factors and trade balance influence the day-to-day exchange rate. The market is very sensitive, however, to political shocks, and the rate can suddenly drop or rise as the market evaluates whether a certain decision will negatively or positively affect one or both of the currencies. Investors prefer to invest in countries with a stable economic and political outlook, and any indicator of potential instability can cast doubt over whether to hold that currency, or invest in that country.
For example, the opening rate on January 27, 2016, was $1.42. A year later, the closing rate was $1.25. This is a drop of $0.16, or 11.5% on the opening rate. Of this, 8.1% (over two-thirds) can arguably be attributed to political fallout from Brexit and Trump's inauguration:
Between January 27, 2016, and June 17, 2016 (1 week before the referendum on the UK membership in the EU), the rate increased by $0.0125 to $1.4358. This shows an increase of 0.8% in the exchange rate over nearly 6 months. This is arguably due to the exchange rate tracking economic factors as normal.
Between June 17 and June 23 (the day of the referendum) the rate increased by $0.0521 to $1.4879, before dropping by $0.1568 to $1.3311, a week later. Due to the Brexit vote, the rate increased by 3.6% before dropping 10.5% over 2 weeks resulting in a net drop of 6.9% - 8½ times the magnitude of price changes over the past 6 months.
Similarly, the rate dropped 4.7% from $1.2975 on September 26 to $1.2363, 2 weeks later due mainly to UK Prime Minister Theresa May's announcement that Article 50 would be triggered by March 2017 and several EU leaders' announcements that they would not offer the UK a good leaving deal.
First, we consider the economic factors expected over 2017 in both the UK and the US and consider whether this is likely to have any dramatic effects on the rate, and estimate the rate changes over 2017 due to economic information.
Then, we consider the political side of the exchange rate, to see when and by how much, the currency market is likely to change. These are points of immense volatility - both offering high potential earnings for a speculator and high potential risks.
Interest Rates, Inflation and GDP comparison:
When analyzing interest rates and inflation, there are two important additional variables to consider. The first is GDP growth - central banks want the economies to grow at a rate that enables job creation and higher tax revenues. The second is the wage growth - if wages increase at a rate higher than inflation, workers' real incomes will increase each year. Inflation becomes a significant problem when it occurs faster than wages growth, making people poorer each year.
GDP growth in the USA has been between 1.6% and 2.6% annually since 2008/09, with an average of 2.2% overall, and a 2-year average of 2.5%. Meanwhile, wage growth was 2.9% in 2016 and inflation between 1% and 2%. Low interest rate of 0.5% has encouraged spending, but allowed inflation rates to begin to significantly rise. The USA is getting richer every year, as are US workers. In 2017, wage growth is expected to slow and inflation rise. Furthermore, higher inflation would lead to a decrease in the value of the USD, meaning that imports are more expensive and exports less rewarding which could damage GDP growth. In an effort to avoid an inflation problem, the US Federal Reserve announced in December 2016 an interest rate increase from 0.5% to 0.75% and indicated three possible further rises in 2017. Overall, we can expect a proactive approach by the US Federal Reserve to control inflation, medium to high GDP growth and stable economic conditions.
GDP growth in the UK has been between 1.3% and 3% annually since 2008/09 with an average of 1.99% and a 2-year average of 2.64%. Despite this, concerns of the eurozone, Brexit and resurgent GDP decline have kept interest rates low at 0.5%. In mid-2016, the Bank of England announced an interest rate drop to 0.25%. Inflation has been holding at between 1% and 2%, but is expected to rise to 3% in 2017. Meanwhile, wage growth has been averaging 2% per year since 2008/09, resulting in a real wage growth of close to 0% per year. Real wages are expected to fall in 2017. While the UK has seen economic growth, this has not been felt by the workforce. Brexit is expected to be triggered in 2017, and this is likely to cause a drop in GDP growth. We can expect interest rates to hold at a maximum of 0.25% and potentially drop to 0.1% in 2017. Overall, this has led to a less certain economic situation.
Exchange rates are inherently connected to trade. If, one country exports more than it imports, this suggests there is a high demand for their products. As such, there is also a high demand for their currency. This will have an upward influence on the price of their currency. The table shows the trade balances for the US and UK:
Figure 2: UK and US Trade Balances; Global; Billions of USD
Balance as % of GDP
As seen here, both countries have a negative trade balance which will create a downward pressure on exchange rates for both countries. As we are considering both countries, however, it is important to also consider the relative negative trade balances. The US trade balance is nearly a third worse than the UK's when compared to GDP. As such, the US would expect a larger impact on their exchange rate compared to the UK. When considered alone, this would push down the value of the USD and increase the amount of USD that 1GBP can purchase, increasing the exchange rate.
Figure 3: US exports and imports to the UK (2011-2016): Billions of USD
It is also important to consider the reliance that each country has on the other. The US generally has a negative trade balance with the UK. This means that the UK exports more to the US, than it imports from the US. This gives the UK some dominance as more people in the US will buy GBP, than people in the UK will buy USD.
Combined with their comparative reliance on imports, we can see that both countries have a downward pressure on their individual currencies, while the US has a greater downward pressure. In terms of exchange rates, they act as a ratio. As such, if one part goes down more than the other, then the ratio will go up. Due to the fact, the greater US downturn is likely to cause a trade balance based slight upward shift in exchange rates.
Long-Term Economic Input into exchange rates:
For investors, it is better to invest in a stable and high-interest economy. The 0.75% interest rate seen in the USA will encourage US investment, while the UK interest rate of between 0.1% and 0.25% will encourage investors to seek alternatives. Meanwhile, high inflation in the UK will continue to undermine the value of the British pound, while higher interest rates in the US will ensure that the inflation rate does not escalate above its current position. Weakening exchange rates will further devalue exports, and make imports more expensive which will slow GDP growth rates and that will offset the higher GDP growth rates caused by low interest rates.
This will be reflected in exchange rates creating upward pressure on the value of the USD and downward pressure on the value of the GBP. We are likely to see the GBP/USD rate decrease at a heightened rate above the 2016 level. The trade deficit, however, may mitigate some of this decrease as international trade causes demand for the GBP that outweighs demand for the USD, with a diminishing effect as the exchange rate reduces further.
The average January 2017 rate was $1.2325. Approximately, 3% of the GBP/USD rate drop over 2016 was due to long-term economic factors rather than political turmoil-induced shocks. We are likely to see a rate drop of approximately 3% in 2017 as economic factors weaken UK stability, but trade balances prop up the GBP/USD exchange rate. It is unlikely, however, that we will see more than a 3% rate decline as the trade balance provides some counter-weight to investor sentiments.
- 8/10 chance: A decrease in the GBP/USD exchange rate of 3%, resulting in a rate of approximately $1.19-1.20 in January 2018.
- 2/10 chance: An accelerated decrease in the GBP/USD at a rate of approximately 4.5%. This is due to a 50% increase in the US interest rate, with further increases expected in 2017, with an expected constant 0.25% UK interest rate. This would result in an exchange rate of approximately $1.17 to $1.19 in January 2016.
Potential Political Shocks:
In June 2016, the British people voted to leave the European Union. This resulted in a net drop in the exchange rate of 6.9%. In September, at the Conservative Party conference, Prime Minister Theresa May announced plans to formally begin the process of leaving the EU, known as triggering Article 50, by the end of March 2017 - resulting in a further drop in the exchange rates. Throughout 2016, signs that the UK would actually leave the EU caused significant rate drops. As we enter 2017, the rate is likely to drop further.
The first volatile period is late January and early February 2017, when the UK Parliament will debate and vote on whether to allow the Prime Minister to trigger Article 50. While expected to pass, with an estimated majority of 150-200 MPs (Ministers of Parliament), the added amendments could decide the negotiating position of the UK including whether the UK opts to stay in the single market. Speculation about what will happen will cause immense market volatility and the final decision is likely to cause the pound to lose some of its value.
It is very likely that the Brexit Bill will be approved, and, therefore, it is expected to have passed through the entire legislative process by the end of March 2017. This will result in a further drop in GBP. Once the process has begun, the first weeks will be extremely volatile as negotiating positions are set, with upset throughout the year as the market responds to rumors and speculation about the negotiations. The total rate drop due to these shocks is likely to be between 5% and 10%, further decreasing the rate by December 2017.
In the unlikely case that MPs block the Brexit Bill, however, we would be likely to see an initial resurgence in the GBP, followed by very high volatility as the UK economic and political future becomes increasingly uncertain.
Furthermore, as part of Brexit the UK will be attempting to line up trade deals with non-EU countries. Many of these are expected to take years to come to fruition. Announcements by foreign countries regarding the terms of potential trade deals that they would offer to the UK will cause further uncertainty over the UK's post-EU economic future. UK Prime Minister, Theresa May, met with Donald Trump in January and it is believed that he offered a free trade deal to the UK. Announcements such as this would cause the exchange rate to rise suddenly, and then fall back to pre-announcement levels in the weeks after.
Overall, we can expect 2017 to be a volatile year for the GBP/USD currency pair. There will be significantly more expected volatility in the first half of the year, compared to the second half, although politically motivated rate shocks will occur throughout the year. Outside of political shocks, we expect there to be an 80% chance of a December 2017 exchange rate of between $1.19 and $1.20. If the political shocks associated with Brexit go through as expected, this figure could be between $1.07 and $1.13.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for educational and informational purposes only. NOT investment advice.