Pound vs Euro and Dollar Rates Will See Record Lows after "No Deal Brexit" but the Odds are being Overcooked

-"No Deal" sees GBP at record lows against EUR and USD.

-But odds of "no deal" have been overcooked, are actually low.

-"Soft Brexit" remains most likely outcome, leaving GBP stable.

© IRStone, Adobe Stock

The Pound will fall to record lows if the UK leaves the EU without a trade deal next year, according to forecasts from Bank of America Merrill Lynch, although the odds of this happening are being overcooked "by accident or design".

The number of government ministers making pronouncements on the probability and perceived dangers of a so called "no deal Brexit" has risen sharply during recent weeks as the negotiations enter their final stages. 

This has brought with it a litany of headlines attributing each downward movement in the Pound-to-Dollar and Pound-to-Euro exchange rates to increasing unease over the trajectory of negotiations.

However, the odds of the UK departing the EU without any agreement at all have not actually risen during recent months. Neither has the market's view on the probability of such ascenario occurring changed very much. 

"We have recently been asked whether a no-deal scenario is being increasingly priced into GBP. We do not think so and believe that such concerns are manifesting themselves in the GBP options market," says Kamal Sharma, a currency strategist at Bank of America Merrill Lynch. "The GBP TWI is broadly unchanged since the immediate aftermath of the EU Referendum whilst our latest flow metrics signal broadly neutral positioning in GBP."

The most contentious issue stalling progress in the negotiations remains the Northern Irish border. The UK government's Brexit Secretary said Tuesday he is confident a deal can be reached while the EU's Michel Barnier said officials from both sides of the English Channel will negotiate with each other continuously until an agreement is struck.

Brussels has always insisted there can be no "hard border" for the sake of peace in Northern Ireland but that there would have to be one if the UK leaves its single market and customs union because, in a post-Brexit world, the UK would operate different trade tariff regimes with different countries to the EU.

This was the impetus for PM May's "Chequers Deal" proposal for the future relationship that means effective single market and customs union membership for all of the UK's goods trade, alongside a "mobility of labour" agreement that has been criticised as code for the continued free movement of labour. 

Despite already having abandoned almost all of her red lines, many expect Prime Minister Theresa May will have to make further concessions to the EU before Brussels becomes willing to declare itself satisfied with the withdrawal negotiations.

Such concessions would merely add to existing domestic political pressures, given the spate of government resignations sparked by the PM's "Chequers Plan", and could give rise to a period of renewed weakness for Sterling. 

"The GBP FX volatility market is already exhibiting signs of stress. GBP could well follow, but we continue to stress that the recent uptick in no-deal rhetoric (by accident or by design) is not a true reflection of the current state of play in negotiations," Sharma writes, in a recent briefing to clients.

Traders are increasingly buying currency "options" that offer protection against sharp falls in the Pound. The advantage of these products is that they are often cheap to buy and the losses incurred if the "options" expire worthless are small.

However, traders buying cheap protection against steep losses in Sterling is not the same thing as the market pricing into the currency a rising prospect of steep losses. 

Sharma and the Bank of America team forecast the Pound will fall to 1.10 against the US Dollar if the UK leaves the EU without a withdrawal agreement. They predict a Pound-to-Euro rate of 0.9565 in such a scenario. 

However, they say the  prospect of this happening is low. Instead the PM is likely to agree a "soft Brexit" that leaves the Pound-to-Dollar rate trading around 1.32 at the end of March 2019 and the Pound-to-Euro rate around the 1.1478 level. 

The Pound-to-Dollar rate was 0.15% lower at 1.2884 and the Pound-to-Euro rate 0.12% lower at 1.1134 during early trading Wednesday.

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