The British Pound might not be as stable as it looks.
In the aftermath of the 2016 Brexit vote, the British pound hit a 31-year low and lost nearly 20% of its value against most other currencies. As the prospect of a disorderly or no-deal exit from the European Union two years later rises, experts fear more currency pain is on the way.
At the moment, the pound is the midst of a strong recovery. This suggests that reopened Brexit deal negotiations between European Commission President Jean-Claude Juncker and UK Prime Minister Theresa May have fuelled optimism in the market that a new Brexit deal could prevent a hard or no-deal Brexit. But this could potentially set the pound up for an even bigger plummet should things go awry.
“We don’t think the market currently attaches a high probability to a no-deal exit—perhaps 10%-15% probability, based on what the UK bookmakers are quoting,” says Adam Cole, head of FX strategy at RBC Capital Markets. “We would expect a fairly violent reaction if it happened. We would not rule out a fall of as much as 10% in that eventuality.
Jeremy Stretch, head of G10 FX Strategy at CIBC, also predicts a 10% depreciation in the valuation of pound sterling under a no-deal scenario. While he notes the downside risk is not as pronounced as it was in 2016, speculative investors seem largely positioned for sterling weakness: “A no deal exit would encourage the prospect of economic disruption and rate cuts undermining the allure of sterling.”
On the other hand, if a new deal was to take those concerns off the table, Stretch believes that it could encourage a rebound in discretionary spending by consumers and encourage an uptick in business investment: “While Bank of England (BoE) rate assumptions are currently overshadowed by Brexit risks, should such fears be sidelined expect the BoE to come back to focus upon rising wage growth. The uptick is boosting real earnings and opens the way for increased consumption should consumer confidence be boosted by a degree of Brexit certainty.”
If some variant of May’s Brexit deal, or an alternative deal, is approved by UK's parliament, the pound's rise could be modest. Cole estimates a 2%-3% bump under a soft Brexit scenario would push much of the uncertainty into the transition period. From a purely market standpoint, the ideal would be a second referendum that reverses the 2016 Brexit referendum result.
“The main issue in the near term is uncertainty and how polarised the most positive and negative outcomes are,” says Cole. “Pound implied volatility reflects these 'fat tails' and hedging against an extreme outcome is expensive, relative to other currency pairs.”
Currency risk is just one of many strains facing companies following Brexit Stretch notes, with the main concerns for European companies being the prospect of breakages or delays in supply chains, potential tariff and non-tariff barriers, and changes in market valuations as a by-product of market disruption. “With a lack of market certainty, it makes sense for corporates to look for a degree of optionality in their strategies,” says Stretch.