London: The last thing the Bank of England (BoE) wants right now, one suspects, is a precipitous fall in the value of the pound. Yet with the worst Brexit fears intensifying, that’s exactly what it may have to brace for.
The BoE raised interest rates this month to a decade-high of 0.75 per cent, citing its belief that the UK economy is operating almost at its “speed limit”, or full capacity, raising the prospect of more home-grown inflation pressure ahead.
Inflation, while easing, has been above the Bank’s medium-term target of 2 per cent target for 18 months. A material fall in sterling would likely yank it back up towards 3 per cent, complicating the bank’s ultra-cautious rate-raising plans.
After lifting rates last week, BoE governor Mark Carney indicated that market pricing of only one further hike over the next 12 months and two over the next 24 was a reasonable assumption. Would he and his colleagues look through an exchange rate-driven surge in inflation, or feel compelled to tighten more aggressively? Having agonised over last week’s quarter-point move for so long and having laid out such a gradual tightening path, the suspicion is it’s a decision they’d rather not have to make.
Britain has gone from the fastest-growing G7 economy to one of the slowest and was the only one to experience a slowdown in growth last year. And the uncertainty surrounding Brexit is deepening.
Ominously, the pound has begun to lurch lower. Little surprise, perhaps, after Carney said the probability of a “no deal” hard Brexit is “uncomfortably high”, and UK trade minister Liam Fox put it as high as 60 per cent.
The mood music is suddenly discordant. Talk is rife of stockpiling food and medicine, and the army being called in to maintain public order in the event of a hard Brexit. Prime Minister Theresa May is reported to be planning a meeting of her cabinet next month to discuss how to cope with no deal.
The pound has plunged through $1.30 to a one-year low against the dollar, the euro is above 90 pence for the first time this year, and volatility has spiked. On a trade-weighted basis, sterling is less than 4 per cent away from its Brexit low.
Options market pricing and investor positioning suggests it could get a lot worse for the pound before it gets better.
As recently as April, it was as high as $1.43 and within five cents of where it was the day before the Brexit referendum in June, 2016. It’s since lost more than 10 per cent, and $1.20 is now in sight.
The euro now has 95 pence in view. If that’s reached, talk of euro/sterling parity will surely resurface.
One can argue the pessimism is overdone. The deterioration in sentiment has been sudden and considerable, not justified by a commensurate change in UK economic fundamentals. A pause or a pullback is surely due.
Based on hedge fund and speculator positioning, selling momentum in the pound is greater now than at any point in five years, and the second-greatest since the US Commodity Futures Trading Commission started compiling data in 1995.
That won’t last, right? And in any case, chances remain a Brexit deal of some sort will be struck with the European Union.
But sterling traders aren’t taking any chances and are scrambling to buy options protection. On Wednesday, three-month implied volatility in sterling/dollar had its biggest rise in six months.
Sterling risk reversals fell to the lowest in 17 months, evidence of investors rushing to protect themselves against more downside between now and into 2019 by buying “put” options.
While funds and speculators have upped their bearish bets on the pound, there’s room to ramp them up further. Their short position now is big, but it’s been significantly bigger on at least six other occasions in the last decade.
In a note published this week titled ‘Trading the Brexit endgame’, analysts at Morgan Stanley recommended buying three-month options, which they say are still cheap relative to historical averages.
They say the pound could fall to $1.25 in the near term, while Standard Bank’s Steve Barrow reckons $1.20 is possible.
But they agree that if a Brexit deal is reached, the pound’s outlook brightens considerably.
Morgan Stanley estimates fair value for the pound, on a purchasing power parity basis, at $1.39, and says it will strengthen to $1.50 by the end of next year, assuming a hard Brexit is avoided.
Sterling bulls may have to endure short-term pain for long-term gain.