Market Directions--Sterling Will Rise if the Brexit Talks Succeed, but Also if They Fail

For the past two years markets have known two things about the UK exit from the European Union. First that the Europeans and the British would find a path through Brexit and preserve the trade and financial relationships so important to their economies.

Second, if the negotiations failed and Britain fell out of the EU the risk would be borne primarily by the UK economy and the pound.

The first assumption became less secure after the EU rejection of Prime Minister May’s Chequers plan and Ms. May’s combative speech on September 21^st.  

Certainty took another harder knock over the past weekend with Prime Minister Theresa May’s decision to “disengage” from the EU exit talks. 

The second assumption has continued unchallenged but the possibility of a complete break necessitates another look at the conventional risk assignments. But first a bit of history.

The initial shock and panic from the June 24th vote two years ago drove sterling down 19 percent against the dollar in six months, from an open at 1.4870 on that June morning to a low of 1.2043 in January 2017. By October the pound had also lost 18 percent against the euro. In comparison the euro lost 9 percent against the dollar, half as much, from that June open at 1.1390 to its December 20^th low at 1.0385.

Once the novelty of the exit had subsided, the logic of the economic and cultural links reasserted themselves and the pound recovered.

By April of this year the sterling was at 1.4376 retracing 83 percent of the June 2016 to January 2017 loss. The recovery against the euro was less, about 50 percent to April 2017, followed by another long leg down to August of that year.  The euro in contrast moved steadily higher against the dollar after its December 2016 low, topping out at 1.2508 in February 2018, 10 percent above where it had opened on that June 24^th.

The promise of a negotiated Brexit was the primary reason for the pound's recovery against the dollar in 2017 and versus the euro from August 2017 to April of this year.   Markets were content to ignore Prime Minister May’s failed bid for a parliamentary majority that June.

However, as the talks proceeded this year, the conciliatory approach of the May government led to the resignation of David Davis the Minister for Brexit and Boris Johnson, the Foreign Minister and leading departure politician in early July.

By that time the sterling had fallen 7.5 percent to 1.3260 from 1.4376 three months earlier. It continued lower until mid-August touching 1.2710 on the 16^th.  On the euro/sterling cross the pound fell modestly from 0.8633 in the middle of April to 0.8850 in the first week of July but then accelerated lower after the resignations to 0.9082 on August 28^th.

A renewed bout of optimism for the pound at the completion of the preliminary talks and the start of discussions on the departure terms lasted from August until Prime Minister May’s speech on September 21^st.

In her speech the Prime Minister sharply criticized the EU rejection of Britain’s Chequers plan for separation.  Market reaction was relatively muted. The pound fell from its 1.3264 close on September 20^th as low as 1.2919 on October 4^th.

While the assumption that the UK and the European Union will come to an agreement is still operating, hence the mild currency response to Monday’s ‘disengagement’, there will not be terms for approval at the EU summit on Wednesday. And while the current impasse is seen as a negotiating tactic by both parties, the further the deal slips off schedule and toward the exit date of March 29^th, the more difficult it all becomes.

Without debating the possibilities or the merits of the British exit, what might a ‘clean Brexit’ mean for the sterling and the euro?

If the UK leaves the EU in total the shock will initially pummel both currencies. Thereafter much will depend on the level of the euro/sterling cross. The dollar levels of sterling and the euro will hinge on any change in the perceived danger to the EU economy, to the political union and to the euro of an unmediated exit.

As noted above the sterling lost 19 percent against the dollar and 18 percent versus the euro after the vote. It remains down 11 percent for the dollar and 15 percent against euro at the close on Monday. The euro is 2 percent higher against the dollar than it was at the open on the 24^th of June.

In the two and a half years since the Brexit vote the political situation in the European Union has changed dramatically

EU authority is under pressure on many topics and from many points within the Union. In Italy, Poland, and Hungary where populist governments unabashedly defy Union rules, in Germany where opposition to Chancellor Merkel’s immigration policy has fueled the rapid rise of left and right parties, and even in France where Macron ran against both sides of the existing political establishment.

The failure of the Brexit negotiations would bring market and media attention back to the European Union and lay bare all of the divisions and inconsistencies in EU politics, economics and finances. It would force the recognition that EU’s weak internal structure is inadequate to face down its burgeoning nationalist challenges.

How might this impact the currencies?

For sterling there are few parameters beyond the January 2017 low of 1.2043 and the brief spike to 1.1450 on October 7^th 2016. The sterling has not been that low against the dollar since the early days of floating exchange rates in the 1980’s.

But the euro has and the early history of the united currency offers a guide for conjecture.

After the euro launched in 1999 it traded down to 0.8243 against the dollar in October 2000 and from February of that year until November 2002 was below parity.

If we take the current euro/sterling cross rate of 0.8800 (10/15/18) as a template for the sterling, parity in the euro would equal a sterling rate of 1.1363 against the dollar. The euro low of 0.8243 would equate to a pound rate of 0.9367.

These sterling rates assume a constant relationship between the pound and the euro. But if the euro weakens as a result of a Brexit failure, a development with strong possibilities, the picture changes considerably.  Historically the range of the euro/sterling is wide from its all-time low of 0.5729 in May 2000 to the financial crisis inspired pinnacle of 0.9799 on December 29, 2008.

On the morning of the exit vote in June 2016 the euro/sterling cross opened at 0.7600. Taking that as the standard parity in the euro equates to 1.3157 in the sterling against the dollar. The low of 0.8243 equals a sterling rate of 1.0843 versus the dollar.

If we take the mid-2015 cross level of 0.7000, parity in the euro equals 1.4285, 0.8243 is 1.1775. At the April 2002 level of 0.6200 in the euro/sterling the cable rates against the dollar are 1.6129 and 1.3295.

A euro level of 1.1100, common throughout 2015 and 2016 is equal to a sterling rate of 1.2500 at 0.8800, but it is 1.3750 at 0.8000, 1.4474 at 0.7600 and 1.6667 at 0.6600.  

The assumption that Brexit risk falls most heavily on the UK and sterling is no longer tenable. The political and economic trials of the Union have mounted steadily in the last three years. It is the Brexit drama itself that has permitted markets and the media to treat the many problems of the EU as separate occurrences unrelated to each other rather than as symptoms of the Union’s structural, political and economic ills. 

Remove Brexit and the EU takes center stage.  Remove Brexit and the euro falls and the sterling rises.

Charts: Reuters Eikon