It's a Mistake to Believe the British Pound has seen the Worst Pass

• Pound to Euro exchange rate today (20-3-16): 1.1533
• Pound to Dollar exchange rate today: 1.2418
• Pound to Australian Dollar exchange rate today: 1.6065

Analysts at Commonwealth Bank Australia (CBA) have shot-down the view that Pound Sterling has absorbed all the bad news surrounding Brexit and is therefore unlikely to suffer any further substantial losses.

In a note to clients dated March 17, CBA analyst Peter Kinsella warns that markets are far too sanguine regarding the risks to Pound Sterling.

“In our view there are significant headline risks for GBP exchange rates over coming weeks and months,” says Kinsella. “Some analysts argue that current exchange rates discount the forthcoming negotiations but we disagree.”

An example of such pro-GBP thinking can be found at Forex.com where we report analyst Fawad Razaqzada believes the Pound could be forming a base against the Dollar.

Backing his assumptions, Kinsella takes a cursory look at 3 month – 1 month volatility spreads for a clue as to the risks the market is pricing over coming months.

In short, these volatility spreads offer insurance on any significant volatility in coming months and the markets are found to be taking a sanguine view of the negotiations.

“The 3 month – 1 month vol spread trades at close to pre-Brexit levels. This is a mistake. Both sides will approach the negotiations with a strident tone, and this will unnerve markets, with malign consequences for GBP exchange rates,” says Kinsella.

Tough Negotiations

CBA believe the opening stance of negotiations is likely to make for interesting reading.

The EU want to finalise the ‘divorce bill’ before proceeding to discuss the future trading relationship with the UK.

The UK negotiators want both issues to run concurrently.

“In layman’s terms, the EU want to remove the possibility of the UK adopting a ‘carrot and stick’ negotiation strategy, i.e., the UK agrees to pay a substantial divorce bill and in return expects a favourable trade deal,” says Kinsella.

Reports from the EU Commission mentioned a potential settlement of 60 billion EUR.

“We think this likely represents the upper limit of any settlement and we fully expect it to be substantially lower, once the horse trading begins in earnest,” says Kinsella.

Indeed, a House of Lords committee found that the EU cannot enforce their proposed €60B divorce bill saying:

“We conclude that if agreement is not reached, all EU law — including provisions concerning ongoing financial contributions ... will cease to apply and the UK would be subject to no enforceable obligation to make any financial contribution at all.”

The Government welcomed the findings showing that the EU and UK will likely immediately be at loggerheads.

Game Theory

CBA think there will be difficulty in addressing the competing interests of all negotiating parties.

Kinsella says we should think about it from a game theory perspective:

“The UK has one aim during the negotiations which is to achieve a trade deal with the lowest cost.

“The EU have to satisfy the competing interests of 27 EU members; the French want to take as much business as possible from the City of London, the Germans want to ensure that the UK is not better off post-Brexit (preserving the attractiveness of the EU as an entity), while the Irish want to keep the closest possible trading relationship with the UK.

“The possibility for a malign outcome is significant.

“This is another reason to hold a negative view towards GBP prospects in the short term.”

Bank of England to Cut Rates Again

Certainly, the decision-making process at the Bank of England will remain key to Sterling's evolution over coming weeks and months.

We saw the Pound jump following the Bank's March policy decision in which it was shown the next move on interest rates will likely be up.

This too is misguided believe CBA.

"We expect UK household consumption will deteriorate somewhat once higher inflation and lower wage growth begin to bite, but this is an issue for later in the year," says Kinsella.

CBA think that the BoE could ease policy further in Q3.

A "fly in the ointment" cited by CBA is that that overseas investors reduced their gilt holdings considerably in recent months.

This had little, if any, effect upon gilt auctions, which benefitted from strong bid-to cover ratios in recent weeks. Kinsella argues this cutting back of exposure is an entirely sensible decision for unhedged investors, given the increase in GBP volatility and the market consensus that further easing measures from the BoE will not be forthcoming.

However, from a currency perspective note how this prompts weakness in the EUR/GBP exchange rate:

Above: Foreigners sell gilts, the Pound falls against the Euro as a result. Image: CBA

Losses Possible

Bottom line, headline risk will remain elevated for the coming weeks and CBA  believe moves below 1.20 in GBP/USD are entirely possible.