Sterling still overvalued, Goldman Sachs cautions

Analysts at Goldman Sachs cautioned clients that the fall in Sterling might have further to run even after having already dropped by 14% on trade-weighted terms following the Brexit vote in June.

"The case for Sterling lower therefore still stands, even with recent sharp declines [...] and we maintain the view that there is downside risk to our existing forecasts," analysts Robin Brooks and Michael Cahill said in a research report sent to clients on 18 October.

"Our main result is that – even with the large declines that have already occurred – the trade-weighted Pound is still around 10 percent overvalued if a smaller current account deficit is the norm going forward. In short, Sterling is not yet cheap."

Many argued that the Pound was "very cheap" on standard valuation models.

Indeed, their own GSDEER model for cable was now over one standard deviation cheap - the first material undervaluation in a long time.

Yet standard valuation models did not allow for "structural" breaks, with the referendum and chance of a "hard" Brexit a prime example, Brooks and Cahill said.

Unfortunately, models such as GSDEER essentially generate estimates of fair value that are long-term moving averages of the exchange rate, Goldman said, and therefore cannot account for more fundamental changes in the underlying paradigm.

"The problem is that GSDEER and models like it tend to generate estimates for fair value that are essentially long-term moving averages of the exchange rate, which means that they do not allow for structural breaks of the kind that the referendum and the rising odds of a “hard” Brexit clearly represent. In other words, fair value in models such as GSDEER has likely jumped lower, although the extent to which this is the case is difficult (and somewhat arbitrary) to model."

Two weeks before the investment bank reiterated its three-month forecast for the value of the pound against the dollar to decline to 1.20.

However, using a current account-based framework, which was less susceptible to the same issue as standard models, Goldman Sachs found that trade-weighted sterling might fall by between 20% to 40% relative to where it was trading before Brexit.

"We think the BoE’s scope to ease policy depends crucially on inflation expectations remaining consistent with the inflation target," Goldman said in the same report.

As of 1208 BST cable was up by 0.77% to 1.2276.