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Despite a month of selling, the British Pound is unlikely to experience significant weakness going forward according to new research from one of Europe's most prominent investment and commercial banking providers.

BNP Paribas says the Pound - which was until recently 2023's top-performing currency - will likely remain stable in the near term as elevated interest rates at the Bank of England will prove hard to ignore for global investors.

"The GBP offers better carry prospects than its G10 peers, especially as still-elevated inflation means rates may rise more and need to stay higher for longer. Its lower sensitivity to China likely explains the GBP's outperformance versus high-beta G10 peers this summer," says Parisha Saimbi, FX Strategist at BNP Paribas.

In a carry trade, an investor will borrow in a low interest rate currency to buy a currency or asset earning a higher interest rate. Carry trades are one of the most traded strategies in foreign currency investing and are particularly important at present given central banks have raised interest rates from stable, near-zero levels.

The Pound is an obvious beneficiary in this regard since the Bank of England has hiked its base rate to higher levels than most of its G10 peers.

Above: "GBP the highest G10 yielder, even on a vol-adjusted basis" - BNP Paribas.

BNP Paribas expects the Pound's high-carry status (versus the major currencies) and less-China-sensitive credentials to make for a more stable outlook in the coming weeks. "We expect this backdrop to persist near term, keeping GBP stable," says Saimbi.

The call comes amidst a period of underperformance by the Pound that has seen it retreat against most of its major peers and raises questions as to whether further losses are likely as a more notable downtrend envelops the currency.

The Pound is in fact the worst performing of the major currencies over the August-September period, in large part because investors have drastically scaled back the amount of interest rate hikes they still anticipate the Bank of England to deliver.

This goes back to the carry trade; as that rate advantage bestowed by the Bank of England becomes less noticeable, the upward pull on the Pound fades.

Medium-term Risks are Sizeable

Downside risks include a likely UK recession that BNP Paribas predicts to come about in the first half of 2024.

"If activity data slow and the BoE puts policy rates on hold as we expect, markets may increasingly price rate cuts through 2024, weighing on GBP," says Saimbi.

Above: "UK reliant on foreign financing" - BNP Paribas.

She adds that the likelihood of net fiscal giveaways - which might typically be expected to boost an economy - at the Autumn Statement looks low. And, "sticky inflation that requires more policy rate tightening than we expect would not be GBP positive, in our view, as tightening would come at the cost of already weak growth (i.e. stagflation would need to be increasingly priced in," says Saimbi.

One potential source of support for the Pound through 2023 has been the narrowing of the UK's current account deficit as a result of falling energy prices.

This means the UK has paid out less in foreign exchange to foreign suppliers than was the case in 2022, which provides an obvious source of support for the currency.

But BNP Paribas says an improvement in UK's current account deficit is unlikely to have continued, leading to a deteriorating income balance and a growing current account deficit once more.

"A weaker income balance can prove costly for a currency. The UK is reliant on foreign inflows, so if cross-border portfolio flows slow amid the global and local slowdown, the GBP may need to stay weak or weaken further to attract foreign inflows," says Saimbi.

Pound Forecasts

They hold a point forecast on the exchange rate of 1.29 for year-end through to the end of the third quarter of 2024, when the rate is predicted to step up to 1.30 ahead of 1.32 by end-2024.

The Euro to Pound forecast is set at 0.85 for year-end, 0.86 for the end of the first quarter, 0.87 for the end of the second, third and final quarters of 2024.