With the UK having formally departed the European Union on Friday, Brexit has finally been accomplished.
Historical momentousness aside, the UK’s formal departure from the EU brings little clarity for sterling.
The pound continues to face two serious risks that are hampering a rally: ongoing political uncertainty, and murky growth prospects.
The impact of Brexit on sterling was momentous, and represented the lowest sustained levels ever seen on GBPUSD (Chart 1).It was also frontloaded, with sterling collapsing some 15% on a trade weighted basis from highs on the day of the referendum in 2016 to October’s lows (Chart 2).
The reason for the size of this fall was simple: the referendum introduced the risk of a disruptive no-deal Brexit, which businesses and investors ran away from as fast as their GBP shorts could carry them.
However, this initial fall also represented the risk of lower growth and increased uncertainty in the long-run. Disentangling the size of these two effects was made somewhat easier by the substantial reduction in no-deal risk seen in Q4 last year, which prompted an approximately 7-10% rally in both trade weighted sterling and GBPUSD (Chart 2).
Sterling’s current weakness relative to recent history, therefore, mostly represents ongoing uncertainty about the UK’s future trade relationships, and about the economy itself.
Looking ahead, the evolution of these two issues will determine how sterling trades…
Firstly, trade with the EU will remain a burning topic.
The range of possible outcomes of trade negotiations remains very wide and includes everything from a broad free-trade agreement to a barebones “Canada-minus” deal or even WTO rules.
The Government has so far said that the UK will not be a “rules taker” post Brexit, while the EU has been ruthlessly firm in protecting the integrity of the single market. This is the kind of problem the EU has previously dealt with using a mix of euphemism, compromise, and just plain can-kicking. But if compromises can’t be found, the risk of a barebones Canada agreement, or even another cliff-edge, still looms.
Secondly, economic data will determine sterling’s prospects in the immediate future.
The MPC has decided that dismal growth at the end of last year can be ignored, in the hopes that reduced political uncertainty and improved global conditions mean that the economy will recover in Q1. It’s now up to the hard data to validate this assumption, particularly investment by businesses.
The Government’s ambition to return growth rates to around 2.8% a year may seem far-fetched. However, with low interest rates and a big increase of fiscal spending, the BoE’s revised growth forecast of 0.8% for this year may yet prove overly pessimistic. If Sajid Javid manages to deliver on such a massive growth boost, the specifics of the UK-EU relationship may end up being beside the point as long as a cliff-edge can be avoided.
As important as the arrival – or not – of a post-Brexit economic boost is in the short-term, the key question is what Britain’s economy will look like in the long run.
On balance, leaving the EU is still likely to present a drag on growth when considered in isolation to other factors, but many big questions remain unanswered, particularly what our future trade relationships will look like.
Above all, productivity growth in the UK has been dismal over the past decade (Chart 3), and in the long run the health of the economy rests almost entirely on if this government and the next can revive it.
Putting Sterling’s reaction to Brexit in historical context
Chart 1: The big picture. GBPUSD 1791-2019
The long run history of GBPUSD begins with a broadly stable exchange rate from 1790 to 1910, with the exception of the US civil war. Large parts of the 19thand early 20thcentury featured the gold standard: an effective peg. The 20thcentury saw a gradual relative decline, punctuated by war and long periods of fixed exchange rates as USD became increasingly dominant as the global reserve currency.
Sources: measuringwealth.com, Bloomberg.
Chart 2: Bank of England Sterling Effective Exchange Rate
The post-Brexit crash in sterling was comparable to the UK leaving the EU’s Exchange Rate Mechanism in 1992, and in a broad sense brought sterling to its lowest nominal exchange rates in history. The declines came after a brief period of strength from 2014-2015 driven by high expectations of rate hikes from the Bank of England.
Chart 3: UK total productivity per worker
UK productivity growth suffered a collapse after the global financial crisis from which it has yet to recover. Achieving the Government’s ambitions for 2.8% annual GDP growth would require a return to pre-crisis trend levels.
Author: Ranko Berich, Head of Market Analysis at Monex Canada & Monex Europe.