Dollar expectations skew GBPUSD

The British pound fell back sharply against the US dollar in hours before Prime Minister Theresa May triggered Article 50 to officially leave the EU. The trouble with using Brexit uncertainty to explain the drop in the pound is that the euro and yen also fell against the dollar. In essence, the drop in GBPUSD was mostly a dollar move on reignited hopes of Trump-led US stimulus than fears over Article 50.

The pound fell against the euro early on ‘Article 50 Day’ but quickly unwound most of the losses as images flashed across the wires of Theresa May signing the letter. Another kneejerk plunge in Sterling after Article 50 is triggered is clearly possible, but seems unlikely.

Market reactions have changed

The way markets react to Brexit news has morphed over time. It would seem currency traders are going through the grief process. Talk of a hard and soft Brexit was the denial. The October ‘flash crash’ was the anger. The surge after Theresa May’s speech on January 17 looks to have ushered in the final stage of acceptance. The now nullified threat of another Scottish referendum was a wobble that Sterling survived. Article 50 finally getting triggered should help remove some uncertainty in the UK at a time when Trump and Le Pen are piling it on in the US and Europe.

Brexit is going to be hard

Theresa May’s letter purportedly contains some details on the UK’s negotiating position. Although the ‘hard’ and ‘soft’ Brexit debate has largely passed, there is still some leeway as to how ‘hard’ it will be. To us, it is not the UK’s position that matters. That the EU has put the UK’s exit fee as top of the negotiating agenda instead of trading relationships is telling. Economically it makes sense for the EU to negotiate a fair deal, but politically its agenda is very different.

‘No deal’ is the biggest threat

In order to prevent other member states being tempted to follow the Brexit model, the EU will want the UK to be the poster child for how bad it is to leave the union. In our view, it is entirely likely the UK comes away with no deal and trades based on WTO rules in two years’ time. We are confident in the UK’s long term ability to prosper outside of a trade deal with the EU, but recognise the uncertainty it would provide near term. If markets get a taste of no deal becoming a reality Sterling will face a major test. The first sign that no deal is likely would be if the EU doesn’t agree to a transitional period.

Bank of England unlikely to ease

If one were to look at UK inflation and unemployment data in a vacuum, Bank of England governor Mark Carney should be signalling the intention to raise interest rates. The rebound in the price of oil and a slowdown in food price deflation have caused a rise in UK inflation and the jobless rate is the lowest since 1975. Of course there other factors at play and we don’t expect any such signal.

The Bank of England’s dovish view of the UK economy post-Brexit will mean they are in no rush to raise rates, but there is unlikely to be the economic justification for further easing. Should the Federal Reserve start to waiver on its pace of rate hikes, GBPUSD could be a major beneficiary. European election risk and quantitative easing from the European Central bank are reasons EURGBP could come under pressure. Without another UK rate cut or more quantitative easing on the table, the risks for Sterling look skewed to the upside.