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May in Last-Ditch Plea to EU, Pound Sterling to Fall on Looming Article 50 Extension say Nordea Markets

Pound Sterling exchange rate outlook

Above: Prime Minister Theresa May in Grimsby. Image © Pound Sterling Live.

- Pound consolidates ahead of major week for UK politics

- Article 50 extension to prolong uncertainty

- Sterling to fall on extension as traders 'sell the fact'

UK Prime Minister Theresa May has today made a final pitch to European Union leaders, asking them to deliver the changes she requires to pass a Brexit deal next week.

In a speech today in Grimsby, where 71% of residents voted to leave, May urged the EU to make "just one more push" to break an impasse on Brexit before she tries to get parliament to back her deal next week.

Parliament is due to vote on May's Brexit plan for a second time on Tuesday, ensuring a critical week for the British Pound lies ahead.

"It needs just one more push to address the final, specific concerns of our parliament," May said, "so let's not hold back. Let's do what is necessary for MPs (members of parliament) to back the deal on Tuesday."

She warned "no one knows what will happen" if the deal is rejected.

Should May succeed in convincing Brussels to give the concessions she requires we would expect a strong rally in the value of the British Pound, but should she fail an extension to Article 50 which will delay Brexit is almost inevitable.

While Pound Sterling remains the best performing major currency for 2019, some analysts say the currency will struggle to advance any further during coming weeks should extension of the Article 50 process be agreed as it would merely prolong the uncertainty hanging over the economy.

"It is Brexit crunch time next week as the House of Commons may face three votes in just three days. Although the mood has clearly changed in a positive direction in the last couple of weeks, there is still a risk of adverse scenarios unfolding. Consequently, we see downside risk for the GBP short-term," says Andreas Steno Larsen, an analyst at Nordea Markets.

MPs are next week set to vote on a series of amendments aimed at discovering 'the will of parliament' as far as the nation's Brexit path is concerned.

"We consider next week’s series of events a classic “buy the rumour, sell the fact” case. Thus, a rejection of Theresa May’s deal and an extension of the deadline are probably already priced in," says Larsen.

Pound is best performer of 2019

Above: Sterling remains the top performing major currency ahead of a pivotal week in UK politics. Image (C) Pound Sterling Live.

Parliamentarians will vote for a second time on whether to approve PM May's EU Withdrawal Agreement on Tuesday 12, March and consensus among analysts and political pundits strongly suggests the deal will be rejected again owing to a lack of compromise from the EU.

The likelihood of such an outcome has risen this week with negotiations between the UK and EU yet to deliver a breakthrough. Recent reports go as far as saying negotiations are close to breaking down.

The initial vote on the Brexit deal will be followed on Wednesday by a further vote on whether to leave the European Union without any formal agreement setting out the terms of exit, which would see UK companies and consumers default to doing business with EU on World Trade Organization (WTO) terms. Most say that would be bad for the economy.

MPs are expected to reject this outcome with previous votes showing little appetite for such an outcome.

A third ballot will then be held on Thursday which gives MPs the option to send May back to Brussels with a request for an extension of the Article 50 exit period that is due to come to an end on March 29.

Nordea Markets scenarios

Scenario roadmap Nordea Markets

Images courtesy of Nordea Markets.

"If May’s deal is rejected as expected, we are confident that the Parliament will shoot down the prospect of a no-deal on March 13 and instead accept an extension of the deadline on March 14. The reason for this is that the House of Commons has demonstrated that it wants to avoid a no-deal outcome," says Larsen.

If Nordea's 'base case' unfolds (majority of 40-70 MPs rejects deal + extension), they expect the Pound-to-Euro exchange rate to head 0.5-1% lower in the coming weeks.

Should May's deal be accepted analysts see the Pound rising 3-4% against the Euro and Dollar.

Larsen and the Nordea team are forecasting that PM May will eventually secure parliamentary backing for her Withdrawal Agreement and preferred Brexit path, but that this won't happen until well into the forthcoming Article 50 extension. There is high uncertainty about the length of any extension, but Larsen says it's likely to be three months.

This is far from an ideal outcome for the British currency because it will not actually remove a no-deal Brexit from the table of options, as the UK could still exit the EU without a deal at the end of the extension period if parliament refuses again to back PM May's plan. Although Nordea says this is unlikely to happen.

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Pound-Dollar Rate to Feel Weight of a Static Bank of England under Brexit Delay Scenario

An additional delay will simply prolong the political and economic uncertainty that analysts say is now weighing on the economy. As a a minimum that will mean the Bank of England is sidelined for even longer than it otherwise would have been.

"Once there is clarity about Brexit, we expect an immediate jump in growth in Q3. Growth should also be supported by a looser fiscal policy (as announced in the recent budget) by roughly 0.3% of GDP. This will, however, probably not be enough to prevent GDP from staying below potential at around 1.0% y/y for 2019. In terms of monetary policy, the Bank of England is currently on “Brexit hold”," says Larsen.

The Bank of England has raised its interest rate by 25 basis points on two occasions since the referendum in 2016, taking the Bank Rate up to 0.75%, and it's said repeatedly in recent months that elevated inflation and a robust outlook for consumer price pressures mean it'll need to keep raising rates in the coming quarters.

Changes in interest rates, or hints of them being in the cards, are only normally made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

Rising interest rates tend to be positive for a currency because they enhance the relative returns earned by investors in the bond market, which serves to attract increased flows of capital from international markets.

Above: Market expectations for Bank of England interest rate. Source: Nordea Markets.

"We have currently pencilled in a rate hike in August on the assumption that a deal is reached in mid-June, but the risk is clearly tilted towards a move later (then likely at the November meeting)," Larsen says.

The problem for the Bank of England is that Brexit is a risk to the economy that could potentially undermine the outlook for inflation by reducing demand, so policymakers have said they're reluctant to make any changes to rates before they know exactly how the Brexit saga will end.

This is an issue for the Pound-to-Dollar rate because the Federal Reserve interest rate has risen sharply in recent years and currently stands at 2.25%-to-2.5%. This means investors can increasingly earn a greater return through buying U.S. Dollars than they can from holding Pounds, which has weighed on the Pound-Dollar rate in recent years.

Larsen and the Nordea team say this differential will weigh even further on the exchange rate in the short-term if the Article 50 period is extended but that an eventual orderly exit from the EU, with a deal of some kind, will enable the BoE to raise rates again and Sterling to recover from deeply "undervalued" levels.

The effect of this will be to prevent the Pound-to-Dollar rate from rising above the 1.32 level until after a deal is reached, Larsen says, although he also forecasts that if PM May were somehow able to get her agreement ratified in parliament without requesting an Article 50 extension the exchange rate could rise all the way up to 1.37.

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