Brexit has come into greater focus recently and will remain one of the dominating stories for the UK and European markets in the coming weeks. We are just one day away from Boris Johnson’s self-imposed deadline and as it stands, we are no closer to a deal than we were 5 months ago. The pound has been choppy amid the numerous Brexit headlines but in the next few weeks, we should have a clearer direction for the currency.
What’s the Latest on Negotiations?
For the past few months, Brexit talks have been deadlocked over two issues. The first is fisheries and what sort of access EUs coastal members will have to UK waters. France is one of the leading voices on this topic from the EU side and are holding a hard-line stance. France want their fishing boats to have the same level of access to UK waters as they did prior to Brexit. The UK have been adamant that this cannot happen.
The second issue in negotiations is that of the level playing field and in particular, state aid. The EU have a rule that member states cannot give any sort of aid to companies if it impacts the competition. The EU are wary that the UK will likely use various types of incentives to encourage companies to set up in the UK after Brexit, but do not want this to happen at the expense of EU companies. The key problem with this sticking point is the enforcement of any agreement. The UK is expected to present a plan to the EU on how it might use state aid, but once a compromise is reached, the EU also want to ensure compliance.
The EU stance on enforcement has hardened after the introduction of the Internal Markets Bill from the UK government. In the EU, the rules are enforced by the EU Commission, but the UK have made it clear that they will not accept the Commission or European Courts having any role in this matter. The EU have accepted this but want a robust plan in place to ensure they are able to retaliate easily if the UK were to break the agreement.
What Is Going on with the Pound?
The pound has been surprisingly resilient this year, despite the UK being one of the hardest hit economies from the pandemic and no clear sign of a Brexit deal. Recently, it has been trading around the 1.30 level against the USD. One of the key driving factors behind the pound’s resilience is the weakness in the US dollar but when you consider some of the negative factors for the pound, it is surprising that it has held up so well.
Apart from Brexit uncertainty, the rhetoric from the Bank of England regarding negative rates has ramped up lately. The markets are increasingly pricing in negative rates for the UK in the next 12 months but this has had little impact on the pound. We have also seen a number of local lockdowns across the UK to stem the spread of the second wave of the coronavirus. This will undoubtedly have an impact on the economy. Although the government have announced further support measures and introduced a new job support scheme, we still expect to see an increase in unemployment along with forced business shutdowns. Once again though, the pound has been unfazed by this situation.
There is then the critical topic of Brexit. A no-deal would be severely damaging for the UK economy but a deal does not make everything rosy. We have to remember that the Brexit deal being negotiated is just a bare-bones deal. It would simply prevent the chaos that a no deal could bring but it is certainly not a comprehensive agreement. If a deal is agreed, then the EU and the UK can always add to the agreement in the future but in the short term, we are likely to see persistent weakness for the UK economy.
Where Will the Pound Go from Here?
The pound may have held up well until now, but even with a Brexit deal, the upside for pound pairs is probably limited. Many downside risks would remain in the economy and businesses would still need to adapt to a different relationship with the EU. I would be looking for the pound to hit 1.35 against the US dollar in the short term on the back of a Brexit deal being agreed. Beyond that point, we would need to assess what the central bank are doing and how the economic recovery in the UK is holding up.
In a no-deal scenario, I would expect the floodgates to open, with the pound falling towards at least 1.15 against the US dollar. Although this is quite some distance away from current levels, keep in mind that the pound can get highly volatile and the move could be completed within a matter of days if we edged towards a no-deal Brexit.
Currently, the likelihood remains for a Brexit deal. The UK look set to ignore their 15th October deadline and continue with talks, which is mildly positive for the pound. I have been in a small long GBP portfolio for a few weeks now and am continuing to hold on to this. I am reluctant to add further exposure just yet but will likely do so if we get a breakthrough in at least one of the sticking points in negotiations. Whether we get a deal or no-deal, we can expect to see movement in pound pairs across the board, so it is worth considering holding a broad portfolio and spreading the risk across multiple pairs.