'• UK election on 7 May to be a source of GBP weakness
• We expect USD to outperform supported by better economic data
• Sell GBP/USD for a 1.42 target on UK election and relative rates
Strategy
The upcoming UK general election on 7 May is likely to be a source of GBP weakness and volatility in our view. Polls have been relatively stable lately, and suggest that the election is unusually open with a very high risk of a hung parliament. Since the April 1997 election, we find that GBP has weakened against the USD in the last two weeks up to election day, possibly reflecting an increased risk premium being priced into GBP as the election approaches (see chart 2). Current polls indicate a high probability of a hung parliament. Given that it is possible that no two parties together will have enough seats for a majority as a coalition, we could be in for a period of GBP weakness which could persist even after the election, as talks to form a government take place. For this reason, we look for GBP/USD weakness in the coming weeks and we recommend utilising the recent increase in spot to sell GBP/USD @ 1.4930 for a 1.4200 target with a stop loss at 1.5400.
Fundamentals
While both the Fed and Bank of England (BoE) are on a similar path towards monetary policy tightening later this year, we consider the BoE to be a ‘light version’ of the Fed. By ‘light’ we mean that we expect the BoE to hike a few months after the Fed and that it will likely hike more gradually. Over the coming months we expect the tendency for negative US data surprises to reverse and expect the market to increasingly price in Fed rate hikes. At the same time, the BoE is likely to signal a more patient stance given that a stronger GBP affects the UK economy more than a stronger USD affects the US economy since the UK economy is more open. Hence, on a relative basis, we expect short-term US interest rates to increase more than equivalent UK rates, supporting the case for a lower GBP/USD ahead of a fed funds hike in September. We target GBP/USD at 1.43 in six months. See Yield Forecast Update: Lack of bonds set to push 10Y German yields to zero or below (17 April) for more detail on our interest rates outlook.
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