Monetary policy divergence between Australia and the United Kingdom and 'fatigue' on the Brexit story favour a higher GBP/AUD argue strategists at global financial services giant Nomura.

Traders would do well to bet on a rise in the Pound-to-Australian-Dollar exchange rate going into year-end, say strategists at Nomura plc, as divergence between market-implied expectations for UK and Australian rates could see the pair rise sharply before the curtain closes on 2017.

The call comes after Sterling sits 2.8% stronger against the Aussie Dollar than it was one month earlier with the exchange rate now 1.26% higher over the course of 2017.

It is argued there is nearly 3% upside to be had in GBP/AUD as markets begin to realise the Reserve Bank of Australia may be intent on keeping interest rates steady for a considerable amount of time while the Bank of England raises interest rates in order to 'normalise' the UK interest rate environment.

So this is a classic case of 'monetary divergence' at work whereby the currency that advances belongs to the central bank which is tightening monetary policy.

Above: GBP/AUD has risen of late, largely as a result of broad-based declines in the Aussie Dollar. But the Pound could find further strength on Bank of England policy.

“There is a clear divergence as to where the RBA and BoE pricing may go. In the UK a slow and steady rate hiking cycle should soon present itself, but in Australia the subdued Q3 CPI should remind the broader market that the RBA has time on its side,” says Jordan Rochester, a foreign exchange strategist at Nomura.

Brexit Fatigue

The case for Sterling strength versus the Aussie Dollar is however more than just a discussion over Bank of England policy intentions.

In the wake of June 2016’s Brexit referendum, the UK economy has held up better than many had expected although the devaluation of the Pound has led inflation to rise and prompted the Bank of England to begin signalling that higher interest rates are now on the horizon.

“It seems 'Brexit'is a word we can’t go a day without, with 'cliff edges' and 'financial exodus' consistently spoken about,” says Rochester. “That repetitive analysis of Brexit tends to warp our GBP tradingview and lead us to miss opportunities that present themselves.”

Markets, and much of the commentariat, have spent the third-quarter on edge over an absence of progress in negotiations between the UK and the EU. But with almost 18 months of negotiations left to go, the economic consequences of the dreaded “no deal” Brexit could be some way off yet.

“The communication the BoE provides next week and the subsequent Brexit negotiation rounds will be key, but the prospect of the market paring back its optimism regarding the outlook for the RBA could give this relative value trade legs,” Rochester adds.

Any “hard Brexit” would mean the UK defaults to trading with the European Union on World Trade Organization terms.

“Given the real 'Brexit bite' is unlikely to materialise until March 2019 or even later if a transitional deal is agreed, it is too soon to use it to validate each and every trading view,” Rochester writes, beneath his trade recommendation.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.Estimates of what a “hard Brexit” means for the economy vary widely.

Some government sponsored research previously suggested it could mean a 4%-5% contraction of the economy, while more recent analysis from HSBC suggests the Pound-to-Dollar rate could fall to 1.10 in such a scenario and a shallow recession that shaves a lesser 1% off the economy might ensue.

“There is, of course, merit in the pessimistic view but for us it’s a question of “how bearish” can you really be on the UK and BoE pricing in light of a global growth cycle and domestic growth that is yet to look materially off course,” Rochester notes.

Growth held up better than was expected during the third quarter (+0.4%), with the economy appearing to regain some of the momentum it had lost earlier in the year, leading expectations of a BoE rate hike in November to solidify.

“We continue to expect a November BoE interest rate hike, and a further move up in front-end rates as the pricing of a cycle comes through,” says Rochester.

Above: Medium-term timeframes show the GBP/AUD is off its lows and maintains a soft upside bias.

Cooling Australia

Meanwhile, in Australia, improvements in the condition of the domestic economy have not been matched by an increase in underlying inflation pressures.

“While there have been improving signs across the domestic economy, particularly in the labour market, and the growth outlook has improved, the RBA is in no hurry to shift the policy dial,” Rochester says.

Policymakers also remain concerned about the impact that higher interest rates could have on debt-laden households in an environment of muted wage growth.

“Limited inflation pressures, as illustrated again by the benign Q3 CPI data and details which show a rising proportion of the basket is growing by less than the bottom end of the RBA’s 2-3%pa target band, support our call for the RBA to remain patient,” the strategist adds.

Rochester notes a cooling Chinese property market and a wave of other reformist policies that are likely to continue to weigh on iron ore, Australia’s largest export, prices toward year-end.

“And with positioning measures continuing to show that leveraged participants are long AUD, this mix of factors and change in market sentiment should keep a broad-based rebound in the currency at bay,” he forecasts.

Above: Long-term timeframes confirm Sterling has substantial room for recovery.

The Reserve Bank of Australia has kept the cash rate unchanged at 1.5% for fourteen months in a row. However, with the global economy picking up and other central banks beginning tighten policy, markets had recently bet the RBA would follow suit in 2018, raising interest rates too, which lifted the Aussie Dollar throughout the summer.

“We think these diverging impulses should see relative market interest rate expectations shift in favour of a higher GBP/AUD,” says Rochester.

Buy GBP/AUD

Nomura has recommended traders buy the Pound-to-Australian-Dollar pair at or around the market price and target a move upward to the 1.7652 level. There is no specified stop loss for the trade.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.