As we have outlined for several weeks now, sterling is becoming more and more exposed to the idiosyncratic risks of Brexit and its exposure to a conversation around negative interest rates from the Bank of England.
The pound has spent a lot of time bringing up the rear of the currency leaderboard since the Brexit referendum nearly 4 years ago and the declines last week have come as market mentality has shifted from broader fears over coronavirus and the recovery from the crisis to individual currency issues.
While the pound was able to shed some of the political risk premium that investors held over it following the resounding win for the Conservatives in December, the inability of the UK and EU to agree a framework around a future trading relationship has reignited those bearish on the pouns.
Talking but not listening
Statements from David Frost and Michel Barnier, the UK and EU negotiating leads respectively, show just how far apart the two teams remain.
Frost described the EU’s stance on keeping a level playing field commitments as an “ideological approach which makes it more difficult to reach a mutually beneficial agreement… we very much need a change in EU approach”.
“We very much need a change in EU approach”David Frost
Barnier’s statement was the bluntest I can remember him being since negotiations began noting that “Despite its claims, the UK did not engage in a real discussion on the question of the level playing field… This makes me believe that there is still a real lack of understanding in the United Kingdom about the objective, and sometimes mechanical, consequences of the British choice to leave the Single Market and the Customs Union…You cannot have the best of both worlds!”
Last week’s developments and the language above has caused us to re-evaluate the chances of the UK and EU agreeing an extension to the current transition period. A last minute fudge is never out of the question of course – this is not just politics, this is European politics after all – but from the point of view of the pound, currency markets are nowhere close to fully pricing the UK leaving the EU on WTO terms at the end of the year.
Nor are they therefore pricing the impact on the UK economy of British businesses having to retarget supply chains on WTO terms months after their operations were forced to shutter following the world’s first pandemic for over a century.
The profound negativity on the pound would be quite something and we would expect sterling to test and extend historical lows against many currencies.
Does negativity mean negative rates?
The Bank of England’s reaction to the Covid-19 crisis has been swift and strong but doubts remain as to whether we have seen the central bank exhaust its policy actions. Speculation has increased that the UK will follow the Eurozone, Denmark, Switzerland, Sweden, and Japan in moving its base interest rate below 0%.
For now, we think that this will not happen; institutional opposition to negative rates is strong and the UK’s reliance on the strength of the financial services sector make it the greatest of double-
edged swords. That does not mean that markets won’t keep the pressure on sterling on the basis that it might happen, and all communications from the Bank of England and its policy committee members will have to be viewed through the prism of negative interest rates.
For now, the die seems to be cast for sterling in being pushed lower as we head into June with little movement on Brexit and speculation on negative rates. A dismissal of both risks would see sterling 4-5% higher pretty quickly but we have learnt that it pays to be cautious when the pound meets politics.
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