Buy GBP/USD as too much bad news is priced in - ING

The result of the UK elections makes long GBP positions attractive as a lot of bad news seems to be priced into a heavily undervalued GBP in view of analysts at ING.

Key Quotes

“History may show that one of the lasting effects of the 2017 General Election hung parliament result was a paradigm-shifting change in the UK’s Brexit stance. It may be way too early to conclude this with any certainty right now, but the loss of Conservative seats – and rise in Labour foothold – suggests that the dial within the UK parliament may tilt towards a ‘softer’ core Brexit view, with some ‘hard’ Brexit pushback. This subtle change makes long GBP positions attractive as a lot of bad news seems to be priced into a heavily undervalued GBP.”

“We believe that too much bad news is priced into GBP, with the currency now reflecting both (1) a short-term domestic political uncertainty premium and (2) medium-term ‘hard’ Brexit risk premium. GBP is undervalued by a significant 15% vs EUR. This is a meaningful undervaluation in both absolute and relative terms and will in our view serve as a cushion against any further pronounced GBP weakness.”

“Our analysis also suggests the current EUR/GBP overvaluation is equivalent to a 12% drop in UK labour productivity. This looks extreme (even for the case of a hard Brexit) and should limit GBP downside from here.”

“The UK election outcome raises a potential for an alternative to the hard Brexit which was what PM May was seemingly pushing for. The loss of the Conservative seats has exposed vulnerability to the strategy PM May was pursuing and leaves her very vulnerable within her party. She now needs to accept a broader range of views within the party to secure a leadership.”

“In terms of hard Brexit, which GBP crosses seems to be pricing in, it would be difficult to push it through the UK Parliament given the very fragile (potential) Conservative-DUP collation. Hence, we see more room for re-pricing.”

“The seemingly conciliatory tone struck by the EU leaders (ie today’s Barnier comments that negotiations will start only when UK is ready) also seems to be marginally decreasing the odds of the worse-case for the UK and GBP (compared to what is priced in)”

“We prefer to go long GBP against USD given our constructive EUR/USD view. We target 1.35 in 6 months on the basis of (a) Hard Brexit being partly priced out of GBP (b) EUR/USD reaching 1.15 due to expectations of ECB QE tapering.”

“Key risks

• Domestic uncertainty remains elevated. From PM May stepping down to the possibility of another general election, there are still generous domestic risks that come with a coalition government that has a slender majority.

• EU leaders play Brexit hardball ahead of key German and Italian Elections: The Article 50 clock is ticking and in the absence of a transition deal, cliff-edge Brexit risks will increase with the passage of time.”

“6-month GBP/USD call spread 

Buy 6-month GBP/USD call spread. Buy 6-m GBP/USD call with strike 1.3200; sell 6-m GBP/USD call with strike 1.3600. Cost 0.66% of notional (spot ref. 1.2741). Maximum potential return 3.0%. This translates into a cost – return ratio of 1:4.6”