"No Fundamental Reason" for Pound Sterling Weakness: Commerzbank's Leuchtmann

Commerzbank analyst says signs the UK could retain much of its financial sector after Brexit suggest any economic fallout may be limited, but Pound Sterling could yet suffer a "depreciation spiral". 

Britain's economy may weather even the hardest of Brexit with only limited damage but the Pound remains just a few down days away from a depreciation spiral as trader psychology is key to what happens next, according to the head of foreign exchange research at Commerzbank.

The view comes amid a rout in Sterling as traders continue to respond to weekend reports in The Times that more than 40 Conservative Party MPs are ready to sign a letter of no confidence in Prime Minister Theresa May and confirmation from the EU's chief Brexit negotiator Michel Barnier that the EU should prepare for a no-deal Brexit scenario.

But, on the Brexit front it is not all bad news.

“There are rumours that US banks are intending to still carry out a large share of their European business from London (as far as regulatory issues allow),” says Ulrich Leuchtmann, head of foreign exchange strategy at Commerzbank.

Reports emerged last week that, following a meeting with Prime Minister Theresa May and Chancellor Philip Hammond, JPMorgan said it now has better clarity on the UK government’s position toward Brexit.

A report in the Financial Times says major US banks are now opting to deploy branch-back structures whereby their existing giant EU headquarters based in London simply become branches for new, smaller European headquarters in the future. Morgan Stanley, Citigroup and Bank of America are among the banks planning to use London branches of their EU subsidiaries to smooth the process of building new headquarters on the continent, says the report quoting five people briefed on the plans.

“So that leaves many market participants to hope that even in a worst case (i.e. in case of a super hard Brexit) the economic damage will be limited so that there is no fundamental reason for GBP weakness. I follow this view,” says Leuchtmann.

Economists and political campaigners have projected an exodus of international financial firms from the City of London after Britain leaves the EU, fears are that such an exodus could damage the economy given the scale of Britain’s financial services sector.

Close to a million London jobs are in financial services while, at the national level, more than 2 million people work across the industry according to statistics produced by lobby group, TheCityUK.

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Pound Could Yet Suffer "Depreciation Spiral"

While Leuchtmann believes the negative impact of an hard Brexit will be "limited" he warns that this does not mean the Pound is safe from deep declines, largely because it is the confidence of traders that matters for Sterling.

"In the end it does not matter for participants in the FX market what they themselves believe, but it is always about what one thinks the others think,” says Leuchtmann.

Leuchtmann warned in October that the British government is out of its depth in the Brexit negotiations and Sterling in danger of becoming trapped in a “depreciation spiral”.

“The longer the trench warfare in Brussels continues without any results the more one has to trust that all other FX traders remain as optimistic as oneself. That may turn out to be ok,” Leuchtmann writes, in a note Monday. “But one should realise that it can also go completely wrong.”

Leuchtmann also warn that there may come a time when, regardless of what traders think about the eventual economic consequence of Brexit (or absence of), traders will react to news-flow from London with increasingly bearish bets against the Pound.

This would be for no other reason than that (selling) is what those traders will expect other traders to do and so a downward move in Sterling would become a self-fulfilling prophecy.

Above: Pound-to-Dollar rate shown at hourly intervals. Captures Monday sell-off.

The Pound-to-Dollar rate was quoted 0.66% lower at 1.3100 around noon Monday after having been as low as 1.3061. Meanwhile, the Pound-to-Euro rate was marked 0.61% lower at 1.1234 after having been as low as 1.1208.

Above: Pound-to-Euro rate shown at hourly intervals. Captures Monday sell-off.

Leuchtmann's comments mark a high point for Sterling which, under pressure from the latest upset in Westminster, won the moniker of the “Mr Bean of the FX market” from another strategist at the start of the week.

“The weakness of the PM’s position, like the incompetence of Mr Bean, is well known,” says Kit Juckes, chief foreign exchange strategist at Societe Generale, in his morning missive.

Even before Monday’s sell-off, Sterling was priced for soggy growth and difficult negotiations with the EU, according to Juckes. This will remain the case regardless of who leads the Conservative Party and the country.

“That’s before we wonder who would want her job in the current circumstances; and before we wonder what her departure might do to the odds of another election, which might well put Jeremy Corbyn into Downing Street,” Juckes adds.

If parliament’s rebel MPs muster the 48 names required by Conservative Party rules to force a vote of confidence or no confidence in the Prime Minister, then the PM would face the greatest challenge to her leadership since taking the party reins from David Cameron.

“Would that be good for Sterling (much softer Brexit) or bad for Sterling (left-wing Labour hasn’t been around since the Pound’s worst decade of all)?,” Juckes muses. “Bumping along the bottom” remains our best guess of what Sterling will do from here.”

That said, a much larger number of rebels would be required to actually remove the Prime Minister from office. Meanwhile, party-wide bid to oust the PM seems a distant prospect, given Brexit-backing MPs are a minority in the Conservative Party and an even smaller minority in parliament.

“We still like being long EUR/GBP at the lower end of the last few months’ range; and we like being short GBP/NOK and GBP/PLN even more,” says Juckes.

December’s European Council summit is seen as a crucial deadline by which EU negotiators must be given the greenlight to begin talking about future trade and transitional arrangements if a deal is to be struck in time for it to be approved ahead of the UK’s planned departure in March 2019.

Meanwhile, political focus remains on the UK where Prime Minister Theresa May’s flagship Brexit legislation, the European Union Withdrawal Bill, begins two days of examination in the House of Commons.

Domestic political events are rarely positive for Sterling and expect the bickering over the bill - particularly amongst the Conservative party - to remind markets that the UK's political structure remains relatively unstable.

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