29 February 2020
A no-deal Brexit could easily push the pound to parity with the US dollar, which has never happened before. Photo: Reuters
A no-deal Brexit could easily push the pound to parity with the US dollar, which has never happened before. Photo: Reuters

What does the pound’s poor week suggest for future performance?

The pound sterling has had a rough ride over the last few weeks, hitting a 33-month low – against a trade-weighted basket of currencies – on July 30. Let’s take a look at the downward pressure on the currency that has been driven by increasing odds of a no-deal Brexit following the installation of the new UK government led by Prime Minister Boris Johnson.

The previous low for the sterling trade-weighted index – as computed by the Bank of England – occurred in October 2016, when then PM Theresa May announced an imminent triggering of Article 50 (by the end of March of the following year) and sketched plans for what appeared to be a hard Brexit. Financial markets interpreted the prospects of substantially impaired access to the European Union’s Single Market as negative for the UK’s economic outlook.

Similarly, the 7.5 percent depreciation since May has also been driven by political developments. In May it became clear that Theresa May’s Withdrawal Agreement had no chance of passing and she would be soon replaced in an attempt to overcome the impasse. It then became apparent that her replacement would come from the intransigent Brexit side of the Tory party. Finally, Johnson and members of his Cabinet, which resembles a hard Brexit task force, have confirmed their unwavering Brexit views and have committed to deliver Brexit on the 31st of October, even if that means leaving the EU without a deal.

Johnson’s attitude has prompted markets to price in a higher probability of a no-deal Brexit. Betting markets are now pricing a ~45 percent probability of a no-deal Brexit, compared with ~15 percent back in May.

The market takes the view that a no-deal Brexit would have a significant negative impact on the UK economy. Most official analyses estimate long-term GDP losses at 5-10 percent under a WTO scenario, but there is uncertainty about the extent of the short-term damage. That would ultimately depend on several conditions, including whether and to what degree temporary extensions of existing arrangements with the EU will apply after the UK makes its formal exit.

What happens next?

Foreign exchange markets will continue to be dominated by evolving political developments, facing several potential pressure points over the next few months.

Speculations of an early general election have intensified in recent days, with Johnson having ramped up spending since his working majority in Parliament fell to just one on Friday last week following a by-election in Wales.

As we approach the Brexit deadline on Oct. 31, we will likely be in a state of heightened volatility. There is a range of possible outcomes, although the government seems to be on a collision course with Parliament (where there is still a majority against a no-deal Brexit). A general election might be the only way to resolve the stall. Big questions loom: will a snap election take place before or after the Oct. 31 deadline? Will Parliament be able to prevent a no-deal Brexit on Oct. 31 (by legislating to extend Article 50)?

Despite opposition to it in Parliament, the new Cabinet has made a no-deal Brexit appear increasingly likely, particularly if we consider that it is the default option according to current legislation and it may happen accidently, if Parliament fails to devise countermeasures. The pound’s recent tumble suggests that a no-deal Brexit could take the currency into uncharted territory.

The recent relationship between changes in cable (the USD/GBP cross exchange rate) and evolution in the probability of a no-deal Brexit in betting markets suggests that in a scenario where markets price in a 100 percent probability of a no-deal Brexit, cable could collapse to 1.05-1.10.

Given the tendency for financial markets to overshoot, a no-deal Brexit could easily push the pound to parity with the US dollar which has never happened before.

Going forward, there is scope for wider ranges of value for the pound, including the possibility of an increase if MPs are able to successfully block a no-deal Brexit in Parliament. But realistically, the next few months don’t hold much promise for the currency. September and October could be wildly volatile months for the sterling.

What would this mean for the economy?

A sharp currency depreciation would act as a supply-side shock, driving a spike in inflation, a squeeze on income and a drag on consumption. Savings would fail to provide an ample buffer as consumers have already dissaved significantly since the EU referendum. In fact, the saving rate is running close to its record low levels.

Business investment may also slow further as a falling pound with potential for further depreciation could spook investors. Furthermore, the benefit of rising exports usually associated with a weaker currency has not yet been felt by UK businesses, which suggests we may see little boost to exports from a weak pound.

The Bank of England would face a trade-off between reining in high inflation and stabilizing economic activity. It would probably look through the temporary spike in prices and focus on activity instead, but it would ultimately depend on relative developments in demand and supply, as well as inflation expectations and financial markets’ confidence in UK assets.

In investment terms, each of the options that the UK currently faces presents its own challenges. In the coming months, a parliamentary impasse or a no-deal Brexit present the most adverse possibilities for risk assets. Even if they look undervalued in a historical perspective, they will not look attractive as long as there is no clarity on the Brexit outcome.

The Brexit process will be unfolding for years to come but for now the persistence of uncertainty seems to be the only certainty, and will continue to weigh on the UK’s currency, investment decisions and economic performance.

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Senior Economist at Hermes Investment Management