The British government and UK politics have rarely been in a more shambolic state, but Brexit chaos may not be the disaster for sterling you might think.
No major central bank is going to raise interest rates much this year, if at all, so the euro and dollar will be hard pushed to capitalize on the pound’s vulnerabilities.
The Bank of England won’t raise rates this year either, and will only hike a quarter of a percentage point by August next year, according to money market pricing. Even one hike in 18 months might be optimistic.
Tuesday’s parliamentary drama was extraordinary. Prime Minister Theresa May suffered the worst margin of defeat of a government in modern times as lawmakers rejected her Brexit divorce deal, and minutes later opposition Labour Party leader Jeremy Corbyn called a vote of no confidence in her government.
Two and a half years after the Brexit referendum and less than three months before Britain is scheduled to leave the EU, there is still no deal, nothing remotely resembling consensus in parliament, and division across the country is deepening.
A Sky News poll on Wednesday showed that 61 per cent of Britons say the country is in a state of crisis. Unsurprisingly, investment is being held back, business and consumer confidence is deteriorating, and the outlook for growth is dimming.
Saker Nusseibeh, chief executive of Hermes Investment Management, which manages 36 billion pounds of assets, summed up the despair felt among investors: “The sad truth is that continued uncertainty has prevailed, and there appears to be no clear plan B.”
There’s a strong case to make that Britain’s political, economic and interest rate outlook is unambiguously negative for sterling.
Yet sterling rose after May’s defeat on Tuesday. Against the euro, a more accurate measure given that over 40 per cent of British trade is done with the euro zone, sterling hit its highest since late November.
And it is inching higher still on Wednesday.
The logic here is that the political turmoil and a possible cliff-edge Brexit will force the March 29 deadline to be pushed back, or ultimately get lawmakers to agree a softer Brexit. The vast majority of lawmakers are opposed to a hard, no-deal Brexit.
Also, currencies do not operate in a vacuum. Economic growth and the prospects of tighter monetary policy across sterling’s main peers is fading too, weakening some of the inbuilt support they might otherwise have enjoyed.
UP, UP AND ... NO WAY
Let’s start with the euro. Germany is flirting with recession, and European Central Bank president Mario Draghi said on Tuesday that recent economic data had been weaker than expected, global uncertainty remained high, and a “significant” amount of stimulus was still needed.
Economists at HSBC revised their ECB call this week. They reckon the window for a rate hike has closed, and now see the ECB on hold until at least the end of 2020. Eonia forwards show that the ECB is unlikely to raise rates before mid-2020.
That is an even weaker rates path than UK money market curve. Both Deutsche Bank and Nomura now recommend buying sterling against the euro.
From the strict perspective of rate differential swings, the pound’s prospects against the dollar might be even brighter, as expectations of how much further the Fed will raise U.S. rates this year are revised.
Late last year, the Fed’s guidance was for three hikes in 2019, even though market pricing was for only one. But trade tensions with China and tighter financial conditions have darkened the growth outlook, and the language used by Fed officials now is almost unanimously softer.
Fed funds futures no longer price in any rate increase this year, and are even beginning to factor in the possibility of a cut. Economists at Goldman Sachs, who had predicted four hikes this year only a couple of months ago, are now going for two.
So while money markets are repricing BoE rate expectations, they are also rethinking the outlook for the Fed and ECB. It is looking increasingly likely that there will be no rate increase from any of them, which could be a saving grace for the pound. No matter how chaotic Brexit is.
Market positioning is also a potential source of support for sterling, at least in the near term. The latest U.S. futures market data (admittedly a few weeks old, thanks to the U.S. government shutdown) show funds and speculators hold a large short position, meaning they are betting on a weaker pound.
So the scope for these accounts to bet even heavier against sterling is limited. And sterling is up over the last few weeks, meaning these funds face a choice: clock up losses while hoping the market turns in their favor, or cover their loss-making positions. Which means buying the pound.