After Brexit vote, pound resumes its long-term decline

Juergen Buettner

The British Brexit vote has caught many market participants off guard, particularly in the foreign exchange market.

Since the Brexit vote on June 23, the British pound has lost 20 percent against the euro. Against the U.S. dollar it is down nearly 20 percent. Together that leads to a trade-weighted sterling index which trades significantly less than the average seen between 1975 and 2016.

The negative price reaction can easily be explained by the assumption that the decision to leave the European Union may heavily impact the growth perspectives of the U.K.

Since Oct. 11, however, the British currency has stabilized and even rebounded a bit. That newfound resilience in turn can be explained by the firmness of the latest British macroeconomic indicators, notably the sharp increase in retail sales in October (up 1.9 percent month-on-month compared with an anticipated increase of 0.5 percent). Also noteworthy is the now robust labor market. The unemployment rate fell to 4.8 percent from 4.9 percent last month, while pay rises strengthened to 2.7 percent from 2.4 percent for earnings exclusive pf bonuses and to 2.5 percent from 2.1 percent for regular wages.

U.K. Supreme Court hearing ahead

What happens next will also be determined by the U.K. Supreme Court hearing between Dec. 5 and 8, when the judges will decide whether to uphold or overturn the ruling by the London High Court. As has been reported, the court has decided that Prime Minister Theresa May must seek the approval of Parliament to trigger Article 50 of the Lisbon Treaty, launching official Brexit talks.

If the lower court ruling is overturned, according to the currency analysts at the French corporate and investment bank Natixis, this will penalize sterling and support the scenario of a hard Brexit, with Article 50 being triggered before March 31, 2017. On the other hand, if the lower court ruling is upheld, sterling’s rebound could show more lasting power, especially since short positions on the British currency are significant. This could lead to an acceleration of sterling’s technical rebound.

“But over the medium term, there will be a Brexit, in what promises to be difficult conditions given the upcoming elections in France and Germany, which suggests that sterling could go on the back foot in the first quarter of 2017,” says Natixis research analyst Micaella Feldstein.

David A. Meier from Swiss private Bank Julius Baer is also skeptical. He forecasts that “Once uncertainty rises after the Brexit process is finally initiated, outflows of foreign direct investment hold the potential to significantly weaken the currency again.“

New record lows against the euro would be very negative sign

In that context it is important to recall another very important point: Apart from temporary interruptions, the pound in relationship to the euro in the long term is a depreciation currency. According to recalculations, the pound devalued since the end of January 1976 from 2.70 to 1.02 GBP/EUR until the end of 2008. Then the pound showed one of its temporary recovery movements before the Brexit vote caused a new weakness. Purely from the chart-technical point of view, it is important that the pound holds above the mentioned record low against the euro. However, should this level be undercut, it would be synonymous with a pro-cyclical sell signal.

To avoid the latter, good economic data would be helpful.

It is not only analysts at Bank of America Merrill Lynch (BofAML) who assume that the fallout from the pound’s decline will start to hit consumer spending in the near future. News of price increases has started to mount significantly of late, ranging from “Marmitegate” to Apple computer price increases. The BofAML economists expect this to start to squeeze real incomes and consumer spending over the winter. That fits with the forecast of independent research firm Capital Economics, whose economists think that inflation will breach 2 percent by spring 2017 and will peak at around 3.2 percent in the first half of 2018.

Optimists bet on the pessimism of market participants

Staying bearish on the basis of macro fundamentals is also a high-conviction call for Swiss banking giant UBS. In the opinion of the currency experts there, the direction is still heading toward leave despite the recent ruling by the High Court, resilient activity data and a less dovish Bank of England’s Monetary Policy Committee. As a result, the correction of the U.K.’s current account deficit via the moderation of the capital flows currently funding it remains the main longer-term driver of the currency, “We continue to expect EUR/GBP to reach parity by end-2017 and stay around this level for a considerable period thereafter,“ according to a UBS report.

The most important factor that currently speaks in favor of the pound sterling is the already widespread pessimism about its outlook among market participants. That means unexpected, but positive surprises could make investors rethink their positioning, including in case new political problems should arise in the eurozone or in the United Sates. With the constitutional referendum in Italy that is set for Dec. 4, especially in the case of the eurozone, such a development is possible.

Brian Martin, head of Global Economics at ANZ Research, points out that, “According to the purchasing power parity, sterling is severely undervalued. Producer price estimates suggest it is 30 percent undervalued versus USD, while the Big Mac index estimates imply it is 23 percent undervalued.“

This means that there is already a lot of pessimism in the price. Taking into consideration all the facts makes a price forecast for the pound very difficult. Nevertheless, anyone with sterling income and euro or dollar expenses who does not want to take any risk is probably well advised to hedge at least a part of the pound sterling position.