Pound Sterling Forecasts vs. Euro and Dollar in 'No Deal' Brexit

Image © Pound Sterling Live, Al Jazeera

The British Pound remains under pressure on Tuesday amidst reports The European Union are now operating on a "working hypothesis of no-deal" after accepting the prime minister "isn't bluffing" about a 'no deal' Brexit taking place on October 31.

The reports follow a meeting on Monday between European Commission officials and Brexit diplomats from the 27 other EU member states.

A senior EU diplomat is quoted by The Telegraph and The Guardian as saying a 'no deal' Brexit appears to be the UK government's "central scenario".

They are reported to have said: "our working hypothesis is 'no deal'."

The Pound-to-Euro exchange rate is currently quoted at 1.0853, the Pound-to-Dollar exchange rate at 1.2161.

Market expectations for a 'no deal' Brexit have risen sharply of late and foreign exchange strategists are trying to establish potential levels that the Pound might be aiming for under such a scenario.

Foreign exchange strategist Jordan Rochester with Nomura - the Japan-based global investment bank - has crunched some numbers and arrived at some tentative answers.

Rochester says the Pound will settle at "hard Brexit equilibrium": this is identified as the level where the UK's current account would start heading into balance, or at least become more manageable in a 'no deal' scenario, such as 2% of GDP.

The problem for the UK is that it is running an historically high current account deficit, one that stood at -5.6% of GDP in the first quarter of 2019.

The current account deficit reflects the situation where the UK imports more goods and services than it exports, ensuring an outflow of currency.

This should naturally put downward pressure on the value of the Pound as the country is spending more with the rest of the world than it takes in.

But for the UK, this outflow is balanced by inflows of investment capital and returns on investments held overseas by Britons: this keeps the value of Sterling relatively stable and above any equilibrium that would be dictated by the current account deficit.

The problem is that in a 'no deal' scenario the UK could find this inward investment capital dries up as investors exercise caution, leaving the Pound 'high and dry': it has to essentially fall to a new level such that the current account deficit finds a balance and the reliance on outside capital is negated. A lower Pound would reduce the incentive to import and increase the incentive to export, thereby driving a balance.

For Sterling, it is also as much about sentiment as it is about the mechanics of the current account.

The declines in the UK currency began in May when then-Prime Minister Theresa May found her career come to an end with the failure to pass the Brexit deal she struck with the EU through parliament.

Since then, Sterling has been falling as markets increase expectations for further political uncertainty and a 'no deal' Brexit on October 31.

Losses have however accelerated since Prime Minister Boris Johnson came to office and confirmed he would pursue a Brexit 'at all costs' by October 31 and that negotiations with the EU could only commence if they committed to dropping the Irish backstop from any future deal.

"GBP is already suffering from the political situation; the pound is not too far from the historical lows. But, given the turn of risk sentiment, Brexit and geopolitics, it is surprising that we are not already witnessing the Pound making new lows. It seems only a matter of time, with the UK on a near snap election footing and the U.S./China talks finding little way of de-escalating anytime soon," says Rochester in a client briefing on Monday, August 05.

So where does the 'hard Brexit' fair-value for Sterling lie?

"The answer is roughly the same as it was in 2016: the pound would fall somewhere to the region of 1.14-1.18 in GBP/USD and 0.95-0.98 in EUR/GBP," says Rochester.

0.95-0.98 in EUR/GBP equates to 1.0526-1.02 GBP/EUR.

Elsewhere, analyst Walter Zimmerman at ICAP Technical Analysis in New York is warning the Pound could fall well beyond parity against the Euro over coming months.

According to Zimmerman, the Euro-to-Pound exchange rate is forming a bullish price pattern, which could see the pair break through parity in the months to come.

The Pound and Euro have never equalled each other on the interbank market, and the current all-time high for EUR/GBP is at 0.9714, reached in December 2008 in the wake of the great financial crisis. This equates to a Pound-to-Euro exchange rate of 1.0294.

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