19 Oct 2020
Brexit brings currency challenges as pound’s moment of truth nears
As the European Union and the UK enter the final stretch in talks to secure a trade deal, sterling has continued to remain volatile. Against this backdrop, corporates face multiple challenges as they prepare for an uncertain road ahead after the Brexit transition period ends.
The pound has come a long way since the relatively tranquil days of 2015 before the meteoric political bombshell known as Brexit landed. Over four gruelling years, the currency has endured numerous blows.
With Brexit’s final impact uncertain and the coronavirus pandemic and global economy also clouding the outlook, there are several things to consider in assessing what corporates can do during a period of potentially acute volatility in the next six to 12 months.
The first thing to consider is why the fortunes of sterling are so intrinsically linked to Brexit. That might seem at first glance to be obvious, but the relationship goes much deeper than the current volatility-generating headlines suggest. Brexit brings into question key considerations around the integrity and structural value of sterling.
At a surface level, Brexit has had a short-term impact on risk sentiment and caused sterling to behave as a volatile asset class. Constant news flow has seen acute oscillations on key currency pairs and the flow of liquidity.
The second more structural consideration is around asset holdings and asset flow. What is happening here could potentially drastically change the nature of how the UK economy interacts with not only Europe but with the rest of the world. That will filter down to institutions, corporates and our individual lives. It will impact how we think about our assets, risk and how we transact with the rest of the world.
Brexit brings into question key considerations around the integrity and structural value of sterling.
For now, sterling has done remarkably well in holding close to the level of reserve currency it had pre-Brexit. But, undoubtedly, as further political uncertainty unfolds, and if there is no Brexit trade deal, there will be a substitution of sterling assets from funds, property and businesses. If we see this exodus from sterling, the currency will certainly weaken.
If we cast our minds back to 2015-16, when the pound was at $1.50 and the sterling-euro exchange rate peaked in the 1.40s, we can propose we did not reach current levels purely because of speculation and conjecture about the final result.
We are down here because, in the meantime, there has been a realignment and repositioning of asset flows, and we need to watch this trend over the next six to 12 months.
A final key variable is monetary policy. Recently, we have heard many comments from Bank of England Governor Andrew Bailey around the feasibility of negative rates. Thus far, sterling has benefited from the likelihood of this seemingly being put on ice. But as the situation around Brexit and the pandemic unfolds, participants in currency markets will keep a close eye on the evolution of rate policy.
Again, if we cast our minds back to 2016, with interest rates about 1%, the UK was competitive in yield terms against the rest of the world. Now, despite the exceptional circumstances in the global economy, we still find ourselves competitive on yield. However, this will change over time and investors and the market may take the view that the Bank of England will act. That will place sterling in a precarious and vulnerable position.
Deal or no-deal?
We have not yet heard final confirmation from the UK as to whether there will be flexibility around a deal. Thus, any comment coming from the British government as to showing a slightly more accommodative stance is likely to be impactful.
It is essential to listen to the mood music. Participant commentary suggests there is a build-up of long positions in the market, allowing clients to benefit if the currency does appreciate over the coming weeks.
Interestingly, this is in the options market – arguably a slightly more cautious method of speculating on where a currency will move. Nonetheless, it signals the market is positioning for a deal.
The final key point is the broader backdrop of the global economy. Even if we get some positive momentum for sterling, it could be upended by bigger global news – such as a US stimulus package or Covid-related news flow. Nonetheless, if a deal is reached, expect a relief rally and sterling to benefit in the short term.
In terms of gauging outcomes, we could see recent highs in sterling-dollar tested at about 1.34. With regard to sterling-euro resistance levels, 1.15 could be breached.
If we do not see a deal, considering we think the market is currently tentatively positioned for one, this could deliver a catastrophic outcome. In this scenario, sterling may fall into a black hole – certainly testing levels we saw in March as Covid-19 hit, and potentially beyond.
We are not out of the woods yet. We remain hanging on every word from Brussels and Downing Street, and currencies will be the first place to look for market reaction. We must prepare for a rocky ride in the short term.
Global risk continues to weigh
Over the last four years, sterling has increasingly become more sensitive to global risk, as opposed to UK-centric risk. That has become apparent in the previous six months as Covid-19 has come to the fore.
As the shadow of the pandemic hangs over the global economy, we must try to understand the role and impact of central banks around the world in the economic recovery. The gravity of US central banking policy, in particular, will have a bearing on how sterling performs in the coming months ahead.
The US presidential election on 3 November is also a significant factor, not for the general risk it carries, but for the implications of a trade deal with the US, which could deliver a maze of potential scenarios.
The UK and sterling still need to try and navigate through Brexit. If the country secures a deal, the currency will be in a sensible place and should have the opportunity to appreciate. However, it still remains exposed to the fallout from Covid-19 and the US election – both of these global narratives will reach some sort of a climax in the coming months.
What can corporates do?
To conclude, we feel sterling-dollar at 1.29 and sterling-euro at 1.10 are historically very low levels. The sense we have is the market is positioning for a deal to be agreed – and sterling will then modestly appreciate.
But we are not out of the woods yet. We remain hanging on every word from Brussels and Downing Street, and currencies will be the first place to look for market reaction. We must prepare for a rocky ride in the short term.
From engaging with our client base, we get a sense of prevailing cautious optimism. However, broader disruption to supply chains and confidence around supply and demand has created a distinctly opaque picture. While most UK importers will have implemented hedging strategies, sentiment indicates these companies believe they will benefit from an appreciation in sterling and better buying opportunities lie ahead.
It is important to note given the backdrop of multiple global risk factors that corporates need to be cautious about fixed hedging obligations for the future. Fixed forward obligations for 12 months ahead may not be the optimum or appropriate risk-mitigating strategy, given the potential for uncertain cash flows and rapidly changing supply and demand dynamics.
Against this backdrop, understanding business risk and unlocking additional flexibility is crucial.
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