Dec 2019. The question we get asked most frequently at the moment from all clients, no matter the sector, is what is likely to happen to GBP over the coming weeks and months.
- Under our working assumption of a disorderly Brexit being averted, we see further upside in sterling
- Namely we see GBPUSD converging towards 1.35 (with risks to the upside)
- That said, it is unlikely that GBP will return to its pre-referendum levels of 1.50 as any type of Brexit will entail a structural hit to the UK economy, keeping growth lower and applying a speed limit to sterling appreciation.
Following a 5.3% gain in October (the biggest monthly increase since May 2009), GBPUSD has somewhat stabilized. This has come on the back of a modest USD rebound as well as uncertainty regarding the upcoming UK general elections on 12 December.
We maintain a positive outlook for sterling as we turn into 2020. This is based on our expectation that a deal between the EU and the UK will be agreed in the UK House of Commons, paving the way for negotiations between the two parties on the future of their trading relationship.
In our base case, the Conservatives (who currently lead in opinion polls by around 10%-12% ahead of the Labour party) will obtain a parliamentary majority that would allow them – without the need of support from other parties – to ratify the EU/UK deal signed earlier in October. Consequently, we see sterling crosses – and especially GBPUSD – pricing out whatever is left of the no-deal Brexit premium in the months ahead.
In that respect, it is worth highlighting that despite the sterling rally during October and the broadly positive headlines, investors have not turned outright bullish on GBP. The CFTC data show a material closing of shorts but speculators remain, overall, short GBPUSD. At the same time, risk reversals (which indicate the difference in value between a call option and a put option of the same delta) suggest that markets have moved prices in favour of call optionality but have not yet shown any sign of significant build-up in long positions. In this sense, the potential for a sterling rally remains meaningful under our base case scenario.
Finally, we see monetary policy implications of secondary importance for the time being. Under a smooth Brexit scenario, the BoE could be seen cutting rates on the back of softer data but we would judge this as limiting (or temporarily preventing) further GBP appreciation rather than reversing it. That said, monetary policy considerations may rise in prominence later in the year.
Needless to say that there is uncertainty about the election outcome, especially when one considers the poor track record of recent opinion polls. However, it is hard to find a scenario in which there will be a strong pro-no-deal Brexit support in the new UK parliament. Potentially, the worst-case outcome would be a thin (or no) majority in favour of the Conservatives that would lead to a hung parliament. That would imply that the prospect of another extension would re-surface with the market trading on headlines. GBP would be biased to the downside in the near term and sterling’s implied volatility would rise.
Given GBP’s undervaluation, a Brexit deal would push the exchange rate higher. Aside from this UK- specific factor, the general USD weakness that we anticipate should also act as an additional tailwind.
However, as 2020 progresses the issue of a potential extension to the December 2020 deadline will likely arise. International experience (e.g. trade negotiations between the EU and Canada) suggests that it is highly unlikely for the EU and the UK to manage and iron out their future trading relationship over the course of one year (or less). At the same time, Boris Johnson has declared that if he becomes the new PM, he will not seek an extension (which would have to be requested by July of next year). While all this may mean that around middle of next year sterling could come under some renewed pressure, we would highlight two points here.
First, Johnson’s strategy has been to campaign in favour of delivering Brexit, hence it seems only natural to resort to these types of statements in an attempt to appeal to Brexiteer voters.
Second, Boris Johnson’s track record on promises over the timing of Brexit has not been good, to say the least. He said that he would not request an extension deadline and that he would deliver Brexit “come what may” by the end of October 2019. Neither has happened, which suggests that his credibility on the issue is fairly weak.
There may be backs and forths, alongside some political posturing, muscle flexing and noise, but we think that the risk premium associated with a disorderly exit of the UK from the EU (the main reason GBP has been trading so weak these past three years) will be priced out, hence we see further GBP upside.
At the same time, we do not envisage a return to the 1.50 area: any type of Brexit will imply some negative structural changes to the UK economy, which will impair investment and growth and put a speed limit to currency’s appreciation.