The Brexit barometer

The Brexit negotiations are having a big impact on the pound’s movements. Is sterling a good gauge of investor sentiment?

If you want to get a taste of political sentiment, you check in with Lord Ashcroft…

For the odds in any type of sporting contest, you visit your bookie…

And if you want to know how investors feel about Brexit, you take a look at the Brexit barometer.

Brexit is either entering the beginning of the end (no deal with Brussels, no more negotiations, Brexit means Brexit)…

Or the end of the beginning (a deal with Brussels, talks about future trade relations, a years-long transition period).

Given what’s at stake, the media, the markets and the masses are trying to interpret everything as a sign.

From Prime Minister Theresa May dancing to ABBA (wheel in the champagne!) to Chancellor Angela Merkel being unable to understand May’s rattled Brexit pitch (stock up the cellar!).

Most of it is just noise and better left ignored.

But one “Brexit barometer” is said to be a fairly accurate gauge of sentiment among investors. Not the day-to-day swings per se, but the longer-term trends.

That barometer is the UK’s currency, the pound sterling.

Looking back

It’s the night of the Brexit vote. Newcastle and Sunderland are racing as usual to declare their results first…

Brexit figurehead Nigel Farage seems to concede defeat when he says he thinks Remain has won. The pound rallies.

But Remain doesn’t win and the markets don’t like that outcome one bit. The pound sees its biggest ever one-day drop and falls to a 31-year low on the currency markets.

It’s a market reaction on par with the collapse of Lehman Brothers in 2008 or the UK’s 1992 exit from the European exchange rate mechanism on Black Wednesday.

The pound remains under pressure for the remainder of 2016.

That’s because the Bank of England makes an “emergency” interest rate cut to protect the UK economy, which leaves investors fearing adverse effects from Brexit.

At the same time politicians on both sides of the Channel exchange unpleasantries, dashing the market’s hopes of an amicable divorce.

The pound keeps tracking the Brexit related news in the year that follows.

The broader sentiment is bearish until a snap election in June 2017 causes May to lose her majority in parliament.

With the new government softening its tone towards Brussels, the market feels a clean break with the EU has become less likely.

The pound rebounds and reaches its highest levels since voters took the momentous decision to leave the EU.

Sterling steadies during most of 2018, going down a bit when insiders sound pessimistic and up again on more positive notes.

From August politicians start singing hosanna, giving markets the impression a deal is in the air. The pound gains 3.5% against the euro.

But then the EU summit turns out to be a bust. Journalists eagerly watching the Brussels chimneys are left disappointed. No white smoke – just regular thick black smoke.

Hedge funds now short the pound while investors move to protect themselves against further drops in the pound.

That’s the (very) abridged history of the pound since the EU referendum.

Though the pound has won back some lost ground, it’s still trading 10% lower against the euro and 13% lower against the dollar compared to where it was before the EU referendum.

Looking forward

There’s still plenty of stuff up in the air five months before the UK’s departure from the EU.

Depending on how the UK and the EU decide to leave things on 29 March 2019, the Brexit barometer’s mercury could rise or fall sharply.

At the moment the pound is in limbo, we’re told. British currency is expected to react strongly to news on the final Brexit outcome.

Either a no deal Brexit will cause the markets to sell the pound. Or a deal with Brussels that survives the “meaningful vote” in the UK parliament will trigger a relief rally.

Bloomberg asked a bunch of currency market strategists about the pound’s future. They predict an 8% drop in sterling if the UK leaves without a deal, whereas a 6% rally could be on the cards if May successfully navigates the Brexit minefield.

The Bank of England’s Deputy Governor Jon Cunliffe adheres to that view. He recently commented that we should brace for large moves in the pound once investors get clarity.

Strategic Intelligence investment director David Stevenson is not so worried about big currency swings, however…

“Almost everyone reckons that sterling will fall on a ‘no-deal’ scenario, either with the EU or in parliament. I believe that ‘no deal’ is now largely priced in to the pound.”

The markets seem to be using the pound as a benchmark of the political considerations of Brexit. But what of its economic value?

Back in 2015, the IMF and the Bank of England argued the pound was overvalued by some 5-15%. Does that mean sterling is now trading closer to its real value?

“I believe the pound is undervalued on what I’d call ‘proper’ economic factors such as interest rate differentials and purchasing power parity (PPP). Using the latter would value £1 at around $1.40.

“And how about this? Reporting on it is muted because it doesn’t fit with all those mainstream doom and gloom stories for Brexit, but last month’s UK government borrowing figure fell to its lowest level in 11 years.

“That’s great news for the Chancellor ahead of next week’s Budget. But it also indicates that the country is doing a fair bit better than sterling’s current depressed value would suggest.”

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