Pound Sterling is defying gravity at current levels argues a leading Scanadavian lender who suggests clients should be prepared for weakness against the Euro over the next three to four months.

The Euro-to-Pound exchange rate, currently quoted at at 0.8932 on the inter-bank markets, will rise over the next quarter as the British Pound weakens once more says analyst Steno Larsen at Nordea Bank AB.

The analyst identifies a number of key political and economic factors as lying behind the thesis that Sterling is overvalued and is now en route to lower levels, but we have questioned a number of points raised.

Nevertheless, Larsen describes his current forecasts for the Pound against the Euro as being generous to Sterling and warns deeper downgrades are possible.

The Pound’s Rise Reversed as Political Risk Premium Grows

For the Pound, politics is the problem as it is keeping valuations below where they should be if economic fundamentals were in charge.

Sterling rose strongly through most of August and September due to a sudden ratcheting up of expectations that the Bank of England would increase interest rates in coming months in light of high inflation and an economy that while not performing spectacularly, is actually doing fairly well.

The Pound-to-Euro exchange rate rose from lows just below 1.08 to highs just above 1.14 before retracing once more. The Euro-to-Pound exchange rate therefore sank from highs just above 0.9260 to just below 0.8772.

At their September meeting, three members of the Bank’s Monetary Policy Committee (MPC) surprised markets by voting to raise interest rates which led markets to reprice Sterling higher.

Currency's tend to rise in tandem with higher interest rates as foreign capital inflows intensify due to the perceived benefit of banking money in jurisdictions which pay higher rates of interest.

But drivers for the Pound soon switched from the Bank of England to politics where uncertainty is the order of the day and the Pound soon gave up its multi-month highs against the Euro.

Larson notes how the Pound then stalled and weakened at the end of September and into October after political risks associated with Brexit and Theresa may's leadership weighed on the currency.

"One thing is for sure. Political uncertainty is not good news for the Sterling - especially not during this toxic Brexit negotiation process," says Larsen

Above: Bank of England rate hike expectations are not enough to counter political uncertainty.

The analyst reminds us of how poorly the Pound fared in the aftermath of the June general election when May lost her majority, and says something similar is happening now and a political risk premium is weighing on the Pound.

"A political risk premium appeared in GBP and currently something equivalent seems to be playing out. Despite firm expectations to Bank of England, EUR/GBP looks to be heading higher again," says the analyst.

The Political Triggers for a Deeper Fall in the Pound

Larsen’s arguments for a weaker Sterling do rely on a number of hypothetical expectations for destabilising political scenarios in the UK to play out.

For instance, Nordea believe there is a strong chance the Prime Minister could be challenged by members of her own Conservative Party once more - not a far-fetched idea considering the dramas that played out around the time of the Conservative conference.

Talk of a challenge being mounted by the Foreign Secretary Boris Johnson was pervasive while a Grant Shapps - a former party chairman - was said to be leading a rebellion of MPs who were seeking May’s resignation.

But, Pound Sterling Live had at the time - and continue to believe - the markets are setting the bar too low for Theresa May’s exit. We believe the Prime Minister is more secure than many would assume considering the weakened position of the Conservative Party in the polls, there is little appetite to risk a leadership change at a time when the populist Labour Party are riding high in the polls.

Above: General elections are typically good for the Pound. Not in 2017 though.

But Larsen also see's potential trouble from Scotland:

"The Scottish National Party will likely not hold back with comments in coming days and weeks. The Catalan developments aren’t exactly weakening the case of a new Scottish push for independence.”

This is an interesting view, as it could easily be argued that what Catalonia has done is throw into the light just how messy separation is and if anything remind Scots of how divisive their own referendum was.

Indeed, the just-completed SNP conference showed the leader Nicola Sturgeon and her team are intent to focus on domestic issues ahead of pursuing separation, in the near-term at least.

So while Nordea to bring up some interesting points, we believe there is a risk in leaning to heavily on the event-risk mentioned.

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The Economy

The Pound’s jump on expectations of higher interest rates at the Bank of England may in themselves be over-exaggerated argue Nordea, given the recent slower run of PMI data for example.

The BoE has never hiked with Composite PMI at only 54, as is the case in the UK at present.

"Usually hikes are in play with PMI composite at 57 or higher. This leaves downside risks to Bank of England pricing and probably also risk/reward skewed towards a negative surprise in November (against our baseline of a hike). With the current economic momentum in mind it looks unlikely that Bank of England will hike more than the (potential) one off in November," says Larsen.

We would however point out that the Bank of England does not use the PMI series as a determinant of policy, rather they look at official inflation and wage data, indeed it has been ten years since the Bank of England last raised interest rates and the team at the top has changed.

Markets might however be rightly accused of being wrong in expecting two interest rate rises in the course of the next 12 months.

Nordea believe this pricing is wrong; at most the BOE will raise rates in November in a "one and done" move.

If they are right and a second rise does not arise, then the Pound could start losing ground.

This is certainly the most compelling element of their bearish expectation for Sterling.

"Modestly Positive" Forecasts for the Pound vs. Euro

Nordea Markets forecast the Euro-to-Pound exchange rate to rise to 0.91-0.92 in the next 3-4 months.

This translates into a fall in the Pound-to-Euro exchange rate to 1.10-1.09 with the achievement of the latter dependent on a deterioration in political risks, as identified above.

However, "if a more uniform approach to the negotiation process does not emerge, we will likely have to revisit our modestly positive GBP forecast. So far we give May and her administration the benefit of the doubt."

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.