Amid Fears of a 'Hard' Brexit, This Is What Analysts Are Saying About the Diving Pound

The pound has sunk below post-Brexit vote levels.

Juckes: Pound's Fall All About Psychology at This Point

Fears over the economic impact of Brexit helped the pound smash through a post-referendum record on Tuesday and register its lowest level against the dollar since 1985.

The market reaction stems from U.K. Prime Minister Theresa May's speech at the Conservative Party conference, in which she said that Britain will begin the formal two-year process of leaving the European Union by triggering Article 50 before the end of March. She added that U.K. government control of migration policy would be a top priority in negotiations to establish a new trading relationship with the EU.

With European officials doubling down on their position that the free movement of people remains a prerequisite for membership of the Single Market, analysts say the U.K. is by default opting for a so-called 'hard Brexit' that would see the country prepared to prioritize control over its borders at the expense of tariff-free access to the world's largest trading bloc.

Strategists say the currency will remain hostage to volatile risk sentiment until more clarity emerges on the how the U.K. will clear legal and political hurdles in its Brexit vision, though some also see value in the sterling at current levels.

Here's a round-up of market reaction.

Strategists at Daiwa Securities Group Inc wrote in a research note:

"The Maltese Prime Minister, who will be chair of the EU’s rotating Presidency in the first half of 2017, has made it clear that without allowing continued free movement of people, the U.K. has no chance of remaining a member of the Single Market. And this is the clear message from other EU capitals too.

Given that a ‘hard’ Brexit in which the U.K. leaves the Single Market and moves to trade with the EU under WTO rules would hit the economy very hard, particularly the service sector, where the U.K. runs a large trading surplus with the EU, the move in sterling is understandable. Indeed, we expect sterling to come under further downward pressure as the Article 50 trigger date approaches and a move below $1.20 seems entirely plausible to us."

Vasileios Gkionakis, global head of FX strategy at UniCredit SpA, extended his bearish call on the sterling — predicting it'll weaken to 93 pence to the euro, from 87 pence currently:  

"The target extension is predicated on our reading of Prime Minister Theresa May’s speech on Sunday in which it became quite clear that access to the Single Market (the point of focus for financial markets) is not at the top of her priority list. In effect, this makes a “hard Brexit” scenario more likely than previously thought, something we believe the market is not pricing in sufficiently. We expect sterling to weaken further against the euro over the coming weeks and months."

Kit Juckes, global strategist at Societie Generale SA, said that a spirited rebound in the U.K. currency might not be on the cards anytime soon despite its sharp lurch downwards on Tuesday:

"There will be fiscal slippage as the Chancellor won't try to hit previous deficit reduction targets, but a significant easing is not on the cards. Nor is the government showing any signs of shifting a position where control on immigration is the hardest of lines in negotiations to leave the EU, and won't be sacrificed or watered down in order to keep access to the single market, particularly for financial services. There's nothing there to soften the outlook for sterling, at all."

Strategists at Bank of America Corp led by Robert Wood forecast a continuation in sterling volatility, given expectations that European policy makers will adopt a hard-line stance towards the U.K. in trade negotiations.  

"For us, this should weigh on the British pound over the coming months but rather than attempting to trade intraweek headlines, we continue to believe that FX volatility is likely to rise as it did in the run up to the EU referendum. Nonetheless, we reiterate our previous views that sterling is a sell on rallies. In our view, policy uncertainty is likely to rise in the coming months and this spells trouble for a currency with large current account deficit. We will be paying close attention to UK sovereign credit default swaps."

Brian Martin, chief economist at Australia & New Zealand Banking Group Ltd, also known as ANZ, reckons sterling shorts are justified, though he calculates the currency could be undervalued by as much as 25 percent in purchasing-power parity terms, which is a way to gauge the buying power of different currencies.

The fact the U.K. is pursuing a risky strategy to leave the EU at the same time as running a yawning fiscal deficit justifies the violence of the sell-off, Martin writes: 

"Given the extent of sterling’s fall, it is tempting to view it as cheap and it may well prove to be. But for now we continue to see downside risks. No one knows what the outcome of future negotiations with the EU will be nor the outcome of trade negotiations between the UK and any other country. So what the FX market is dealing with at the moment is trying to guesstimate an appropriate level of risk premium for holding sterling."

Tempering some of the more bearish sentiment, FX analysts at Nomura Holdings Plc, led by Jordan Rochester, said in a report on Monday that a long sterling position offers value to investors with a medium-term trading horizon.

"The political uncertainty remains high but it’s hard to see how it can get much worse from here as the market has likely realized the higher risk of Hard Brexit now. We are unlikely to learn of anything material apart from the aims stated already until the negotiations start."

The analysts also suggest market expectations of an interest rate cut in November might fall in the coming weeks — a development that would lend support to the sterling — citing a slew of stronger-than-expected economic data since the Brexit vote, with Monday's release of HIS Markit's monthly Purchasing Managers Index for September the latest such example.  

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