Markets might currently be overestimating the amount of Brexit premium left in sterling, argue senior analysts at UBS.
“There’s not as much Brexit premium in sterling as people think,” says Arend Kapteyn, global head of economics and strategy at UBS. “A lot of the discussion I have with investors is along the lines of: ‘Sterling is near an all-time low, it can only go up, it can only get better’. We don’t think that’s the case.”
Kapteyn points out that in the past couple of years, there’s been a major global slowdown and that during this slowdown, economies that are very open and trade dependent – such as the UK’s – have seen their currencies weaken. Therefore, he claims that sterling would have naturally depreciated over this period, even without Brexit.
Research from the UBS team also supports this claim that there isn’t a whole lot of Brexit premium left in sterling. Data highlighted in this research shows that after the Brexit referendum there was a very large increase in real rates relative to the rest of the world, which Kapteyn says should have made sterling appreciate, but didn’t. He views this as Brexit premium, but points out that this real rates differential has now reversed, suggesting that there’s very little Brexit premium left at this stage.
“So we’ve now had this big move in sterling and the question I’m getting from clients is: ‘How much more is it going to move?’ And our answer is: it’s not obvious it’s going to move a lot more,” he continued.
The UBS research team outlines three broad market outcomes related to Brexit based on eight political scenarios for a deal, or lack thereof.
The “Middle Ground” outcome, which sees the EU provide the UK with a Brexit extension until its domestic political impasse is broken regarding a deal, puts EUR/GBP at 0.86 and GBP/USD at 1.34 – the former being pretty much unchanged from where it is today and the latter representing less than a 5% move from current levels. Although they stress that the political situation surrounding Brexit is unpredictable, UBS analysts say that this remains in their minds the most likely outcome right now.
Alternatively, they see a “Hard Brexit” outcome which pushes EUR/GBP to 1.00 and GBP/USD to 1.05 and a “No Brexit” outcome, which moves EUR/GBP to 0.80 and GBP/USD to 1.50.
Interestingly, although sterling has been very volatile lately, John Wraith, head of UK rates strategy at UBS, predicts that this might not persist for very long.
“We had this long period after Article 50 was initially triggered of this phony war where sterling and volatility weren’t particularly bothered about what was going to happen at the end of the process because it was two years long and for some time it wasn’t in focus,” he says.
By contrast, Wraith observes that as Brexit has neared – and with each short extension – there’s been an uptick of volatility in the currency.
“Now, sterling has obviously swung both ways, and at times quite violently, but if you look at the longer-term charts of the Trade-Weighted Sterling Index, we obviously had that big fall through the period leading up to and immediately after the referendum, but it’s actually been in a pretty well-defined range since then, and we’re kind of around the middle of that range now,” he adds.
Wraith claims that the price of sterling has been dictated by what markets think will happen at the end of the Brexit process and that, “if you put a gun to people’s heads”, they would likely decide that on the balance of probability, at some stage there will be a deal and the UK will exit the EU.
“The other [outcomes] have been tail risks that have ebbed and flowed, but that’s been the most likely outcome in the market’s mind since day one. And I would suggest that as you go into the trade negotiation period you’ll see something similar, which is sterling finding a level and then staying there and gauging how things are going and then the closer you’re getting to the deadline, depending on when that deadline is and how potentially moveable it is, things will start to intensify and those tail risks essentially take on a bit more of a life of their own,” he says.
While most of the focus has been on the impact of Brexit on sterling, UBS analysts note that markets might be under-estimating the impact of a no-deal scenario on Europe, judging by the lack of volatility in EUR/USD. In their recent report on Brexit, they note that GBP/USD volatility is at the 90th percentile of its post-crisis history, while EUR/USD volatility stands at just its 3rd percentile.
“This treatment of a no-deal Brexit as a hit entirely idiosyncratic to the UK makes little sense to us in the context of a potential 60-70bp impact on Eurozone growth from an already weak level,” the analysts conclude.