The Pound "Could Fall Hard" on Impending Brexit Deadlock: Morgan Stanley Reiterate Bearish Forecasts vs. Euro and US Dollar

“Should the upcoming European Council meeting on 19 October delay the UK entering trade talks, GBP could fall hard,” says Hans Redeker, a strategist at Morgan Stanley.

Markets are giving EU and UK negotiators the benefit of the doubt with regards to their communicated desire to keep pushing Brexit negotiations forward, but the Pound is at risk were political will to fail. 

With the fifth round of Brexit negotiations now underway, we have heard statements from both London and Brussels urging the other side to yield concessions in order to push talks forward which suggests an impasse might beckon.

But, politicians on both sides have said "the ball" is in the other's court which suggests an impasse might have been reached. Indeed, the UK's Prime Minister Theresa May has said in a briefing to Parliament her government is preparing for all possible outcomes, including no deal being reached with the EU.

To underline May's point, the UK Government also released two whitepapers at the start of the week on international trade and future EU customs policies which set out necessary preparations for no deal being reached.

The prospect of no deal being reached is potentially the worst possible scenario for the Pound which would be rocked by a combination of uncertainty and investor fright.

"The British government seems to be out of its depth when it comes to the Brexit issue. That is relevant for the FX market as this more than encumbers the negotiating process and as the risk of accidents rises, the risk that the end result will turn out in a way nobody wants it to - and thus in a way that is GBP negative," says Ulrich Leuchtmann, economist with Commerzbank after watching May's address to Parliament.

For markets, and Pound Sterling in particular, what matters is how soon the first round of talks can be finalised, which would then open the door to trade negotiations and put to bed doubts over whether a settlement can be reached.

The UK government and other observers had been hoping negotiations could move forward to the subject of trade as early as the European Council meeting October 19 and 20 comes around. But EU officials have warned the prospect of such an outcome is highly unlikely with the UK failing to have met key demands.

The outcome of the fifth round of negotiations will give some hint as to whether the emerging deadlock has been - or is near to - being broken in time for European leaders to agree on entering the second round of talks.

“Should the upcoming European Council meeting on 19 October delay the UK entering trade talks, GBP could fall hard,” says Hans Redeker, a strategist at Morgan Stanley.

There appears little sign the EU 27 are willing to adjust their negotiating position and offer concessions. Michel Barnier, the EU chief negotiator, tried to soften the EU position around the time of the fourth round of talks in order to get trade negotiations started as early as possible, but Redeker notes his proposals have been rejected by Chancellor Merkel and President Macron.

"It appears PM May’s Florence speech failed to have the desired impact in Europe, but has put 'hard-Brexiters' in the UK on alert," says Redeker who has for some time cautioned that a disruptive, no-deal is a likely outcome of Brexit negotiations.

Slowing Economy

Political negotiations don't move currencies directly, they move currencies via the direct and expected economic impact they might have on economic activity.

“Our bearish GBP is not just based on politics. The economic backdrop does not provide any GBP support either and with two BoE rate hikes almost priced GBP remains vulnerable for now,” says Redeker. 

The net result of political deadlock on the UK economy is expected to be negative and allows Morgan Stanley to reiterate a bearish call on the Pound as a result.

“With the housing market moving into recession, if recent PMI data and falling prices in central London follow through nationally,and the demand for non-essential products such as cars falling rapidly, the economy seems in weak shape,” says Redeker.

Redeker notes ongoing weakness in productivity in the UK, which is a good leading indicator for real income growth, and flags the risks posed to the economy by weak wage growth and bloated household balance sheets.

“The economic backdrop does not provide any GBP support either and with two BoE rate hikes almost priced, GBP remains vulnerable for now,” Redeker says.

Morgan Stanley are forecasting the Pound-to-Euro exchange rate to fall to below parity in early 2018, making them the most bearish on this pair in the industry.

The Pound-to-Dollar rate is forecast at 1.24 by year-end 2017, 1.23 by end-March 2018 and 1.23 by mid-2018.

Morgan Stanley added the Pound to its “Sell List” of currencies in late September after market pricing of future interest rate rises appeared to get ahead of itself and the economy showed signs of a continued slowdown.

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