Sterling’s plunge; markets wake up to Brexit

STERLING has had a very choppy history, marked by crises such as 1967, 1976 and 1992. And it

STERLING has had a very choppy history, marked by crises such as 1967, 1976 and 1992. And it is having another rocky period. John Wraith of UBS writes that

Of the many violent recent moves in global markets, the collapse of sterling is one of the most remarkable. In trade weighted terms, the currency has dropped more than 7% in just two months, a fall of a magnitude only surpassed once since the MPC assumed responsibility for setting UK monetary policy in 1997.

Part of the weakness is down to a change in tone by Mark Carney, the governor of the Bank of England, who indicated recently that British interest rates were unlikely to rise in the near future. But that can’t really explain the whole move; after all, the European Central Bank has hinted it will ease policy further, but the pound has still fallen against the euro. Barclays points out that

EURGBP is up about 5% in the post December meeting period. In contrast, EURUSD has been roughly flat over the same period

And though the interest rate rise in December boosted the dollar, markets have been revising down their forecasts for further US rate increases just as rapidly as they have for those in Britain. The pound has behaved more like a commodity currency (the Aussie or Canadian dollars) even though it is a large net importer of commodities. Interesy rate expectations can’t explain these moves.

Mr Wraith’s answer is simple

We believe the explanation for the move lies in the future, not the past. A big increase in the focus on the UK’s EU referendum – which may well be held by the middle of the year – and a concomitant shift in opinion polls that points to an ever closer outcome provide a compelling argument to explain the pound’s demise

He is not the only one. Berenberg, the German bank, has increased the likelihood that Britain votes to exit the EU from 30% to 35%. Kallum Pickering, the bank’s senior UK economist, writes that

The uncertain outcome has led to a weaker sterling, which reflects reduced demand and increased risk for UK assets. But current sterling weakness is probably only a small taste of what would be store for the UK in the unlikely event of an exit.

ING thinks the uncertianty of the vote might lead to a quarter of a point being knocked off this year’s GDP growth, and a further 1.2 points off 2017 GDP (taking growth down to 1.5%) if Britain votes to leave. Morgan Stanley’s economists write that

We expect the outcome to be a close call. We also think that a vote to leave the EU would trigger a major and sustained rise in political and economic uncertainty

Indeed, Brexit could trigger another Scottish referendum to leave the UK. This uncertainty would make it less likely that both domestic and foreign companies would invest in Britain (there was a freeze in investment around the last Scottish poll in 2014). Mr Williams of Berenberg again

If the UK voted to leave, the risk of an immediate and severe weakening in economic activity would be very high and we would not rule out a recession. Consumer and business sentiment could decline sharply, leading to a slowdown in consumption and business investment.

Morgan Stanley also expects a slowdown in investment in the run-up to the referendum (companies will deem it prudent to wait and see). Second quarter GDP will thus be sluggish. All this will make rate rises an even more distant prospect, adding to the “Carney effect” mentioned earlier. ING thinks the pound may slip to $1.32 in the event of Brexit.

Of course, there will be lots of eurosceptics who will dispute the numbers, arguing that Britain will be better off without the dead hand of EU regulation, contributions into the EU Budget and so on. Given all the uncertainties (Norway is outside the EU but has to contribute to the budget, for example), there can be no definitive answer. Minds on either side are unlikely to be swayed by these numbers; confirmation bias tends to set in (you only believe “facts” that chime with your initial opinion).

Axa, the French insurance company, has just come up with a cost of Brexit of 2-7% of GDP, largely down to the effects of reduced investment and consumer uncertainty. In the long run, the British economy would probably adjust to the new reality. Open Europe, a think tank, estimated that the shift in UK GDP by 2030 would lie somewhere in the range of  minus 1.6% to plus 2.2%.

The recent decline in the pound suggests that markets are in the pessimistic camp. One problem is Britain’s current account deficit, which at 4.5% of GDP, needs foreign capital to finance it. In the absence of foreign direct investment, that deficit would be harder to finance; hence sterling’s fall. A fall in the pound could help exporters but that tactic hasn’t been working elsewhere (nor did it for the UK when the pound last plunged in 2008-09)

As Morgan Stanley writes, investors have been slow to wake up to the issue

most clients we speak with still see ‘Brexit’ as a tail risk barely on the horizon

Indeed, Brexit was one of my five possible surprises for 2016. The betting markets still think Britain will stay in; Predict has the odds of Brexit at 30%, Paddy Power at around 36%. But this optimism seems to be based on the theory that the polls are wrong; most show the two sides very close or the Brexit side slightly ahead. Perhaps British voters will shy away from the uncertainties at the last minute and back the status quo. But while they think about it, sterling will be under pressure.