By Laura Cooper
The British pound has borne the brunt of Brexit headlines, recently swinging from multi-month lows to multi-month highs against both the U.S. dollar and the euro. Evidence of this was clear on November 15 when political frictions within the UK government triggered market turmoil and a sharp sell-off in the pound.
Fears of a UK leadership challenge then dissipated. The signing off of the agreement outlining the terms of the UK departure from the European Union by EU leaders on Nov. 25 saw the currency tentatively stabilize.
With the British pound poised to take guidance from how Brexit developments unfold, there are several scenarios for how sterling could perform in the coming weeks. As a result, the outlook for the pound could change materially in a short amount of time.
The state of play
Investor fears that the UK could crash out of the European Union without a deal in place alongside the potential for a leadership challenge to remove Prime Minister Theresa May underpinned a mid-November sterling sell-off. The resignation of cabinet ministers in opposition to the withdrawal agreement sent the currency plunging while financial markets’ expectation for the Bank of England to raise interest rates in 2019 faded and investors sought safety in UK gilts.
Possible scenarios and potential sterling outcomes
The risk of a leadership challenge remains; if the vote were to occur, an outright majority to oust the leader would be unlikely, in our view. But if successful, this could be sterling negative.
Source: RBC Capital Markets, RBC Wealth Management
Parliament vote presents the greatest source of uncertainty
The risk that Conservative MPs could express a lack of confidence in Prime Minister Theresa May has since faded for now, which alongside the signing off of the withdrawal agreement by EU leaders, has seen the pound stabilize (around 1.28 vs USD, 1.13 vs EUR).
The dissipation of risks around a leadership challenge should allow financial markets to focus on the withdrawal agreement vote in the UK Parliament, set for December 11.
In our view, the uncertainty around the vote outcome is likely to be the main determinant of moves in the British pound leading up to the vote. Approval requires 320 MPs and with the 316 Conservative MPs falling short of this number and reports suggesting some could vote against the deal, cross party support will be needed.
As a result, an outcome of the vote is not certain. This heightened uncertainty leading up to the vote points to greater volatility for the pound, in our view.
Pragmatism to prevail?
We anticipate that the withdrawal agreement will pass through the UK House of Commons and the country will exit the EU on the terms agreed. This should cap further downside to sterling as this outcome would rule out the UK ‘crashing out’ of the EU without a deal.
If the agreement fails to gain sufficient support in the UK parliament on December 11, the UK would seek amendments with the EU to ensure that the deal is amenable to the UK parliament leading up to a second vote. The pound would likely fall swiftly and sharply in the intervening period, in our view. Markets would likely increasingly adjust for the rising risk of a no-deal outcome in this scenario.
But it is our expectation that pragmatism will ultimately prevail and an eventual deal will be approved on a second vote. Accordingly, a subsequent relief rally could send the British pound higher as investors price out the chances of the UK exiting without an agreement.
Even so, beyond a near-term bounce following the approval, upward pressure on the currency is likely to be contained. Details around the future relationship will need to be determined, pointing to uncertainty persisting through the transition period and keeping the currency at relatively depressed levels through 2019.
Should the deal ultimately fail, the default outcome would likely be exiting without a deal in place; however, a general election being called on what Brexit should look like could emerge or even the slight possibility of a second referendum. These remain significant tail risks, in our view, but could materially shift the outlook for sterling.
Markets appear to be pricing in greater odds of a second referendum (see chart). However, while the emergence of this could provide significant upside for sterling, this outcome is unlikely, in our view. The logistical challenges and tight timeline in advance of the March 2019 exit date keep us cautious on this outcome actually materializing.
Position for possible outcomes
Going forward, uncertainty around the outcome of the vote in the UK parliament is likely to see financial markets price in a greater risk of a no-deal Brexit outcome. This could contrast with investors also growing more optimistic on a second referendum. As a result, swings in sentiment around the wide-range of scenarios point to pound volatility remaining elevated.
Until greater clarity emerges around the Brexit progress, we continue to hold a negative outlook on the currency.