The crashing pound will recover from its historic low by 2017, according to UBS.
In a memo circulated on Monday, UBS economist Dean Turner argues that an attractively cheap pound will cause Sterling to defy expectations and bounce back.
The pound has been crashing hard since the UK voted to leave the European Union in June, and investors subsequently dumped the currency.
On Monday it fell to a six-year low against the euro, to below €1.10. It also fell to below $1.22 against the dollar — a 20% drop since the Brexit vote.
That makes the pound one of the worst performing currencies in the world this year.
Many banks have argued it’s going to get worse: HSBC believe that the pound will reach parity with the euro by next year. Deutche Bank, too, think the pound will keep dropping: the bank predicts that the sterling will fall below $1.15 by the end of the year.
But while Turner and his team concede that “the pound’s joyride is probably not over as traders react to every twist and turn of the Brexit debate,” they expect the currency to “stabilise and recover over the next six to 12 months,” and predict that the pound will head up to $1.36 in twelve months’ time.
The average price in the first six months of 2016 — before the Brexit effect took hold — was $1.43.
That, Turner argues, will happen for the following reasons.
1. Markets have overreacted
UBS argues that the markets seem to be pricing for a “very hard Brexit” and a sharp deterioration in the UK economy.
UBS doesn’t think either outcome is likely. The note says (emphasis ours):
“Both sides can be expected to make uncompromising demands that are initially poles apart. As the talks proceed, compromises will be made as they always are. Economic common sense should prevail. Among the items at stake are some GBP 222bn of goods and services that the UK exports to the EU, and approximately GBP 290bn worth imported by the UK from the continent.
“To be sure, the UK is unlikely to go on enjoying the same level of free trade it has with the EU today, but both sides have the scope and incentive to compromise in their mutual self-interest.”
If negotiations do start heading in the direction, the pound would be likely to rally.
2. A cheap pound will stop traders from shorting it
UBS thinks the pound is now undervalued — meaning that the rate at which it can be exchanged for other currencies is too low. Take a look at the chart below:
While that discount is unlikely to end any time soon, investors at current levels are going to start thinking twice before they take out a new short position on sterling. In other words, investors will hesitate before they take up positions against the currency.
3. UK assets and bonds look attractive to international markets
A fall in the sterling means that UK assets — including property, companies, and bonds — are looking more attractive and affordable to international investors.
Turner told Business Insider: “Whether or not the fall in sterling sufficiently compensates for the uncertainties around Brexit is as yet unclear, only time will tell. But if this proves to be the case, then demand from overseas could pick up, which could be a supportive factor for the currency.”
4. A weaker currency is going to shrink the current account deficit
The weaker currency is likely to shrink the UK’s huge current account deficit, which is at a near record level.
Having a current account deficit means that the value of a country’s imports of goods and services is greater than the value of its exports. It’s considered dangerous for an economy to have a large current account deficit, because a country needs to plug the gap with high levels of borrowing.
When a currency falls, exports become more competitive and imports more expensive, meaning we should see higher levels of exports and lower levels of imports, which would in turn shrink the current account deficit.
This, UBS say, should remove another reason for investors to sell the currency.
Here is UBS’s prediction for the pound’s performance over the next twelve months: