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Brexit Currency Shock Still to Come Warn ING

The GBP to EUR conversion is forecast to fall yet further by two leading research houses, while Capital Economics and the Bank of England remind us why weakness in the currency is a good thing.

pound currency shock warnings

Having fallen to its lowest level against the dollar since 2009, the pound is now about 7% lower than its previously close relationship with expected interest rate differentials would suggest, pointing to a significant Brexit effect.

We were speculating on the prospect of a cheeky bounce off the 1.28 support region which has held the pound up for 8 out of the past 11 days. The question now is whether this level of support is finally being eroded and opening the door to deeper declines.

"There is clearly scope for sterling to fall further as the referendum nears, especially if the polls start pointing to an actual exit. After all, the pound’s fall has come despite recent polls indicating that more people will vote to stay in the EU than leave," says Vick Redwood, Chief UK Economist at Capital Economics.

Adding to the negative tone on GDP, as if it needed it, analysts at ING say they see the potential for a ‘currency shock’ lying on the horizon if a Brexit becomes a reality, or if polls begin to show a widening divergence in favour of leaving.

“The economic and political costs of a Brexit are likely to dawn on investors as we approach the June vote, and that this could lead to a risk of sudden volatility," says the research note, "As such, the pricing in of any Brexit risk premium could manifest itself swiftly and aggressively (while only fully showing up in the weeks or months leading up the vote).”

That said, downside potential for the euro is also significant given Mario Draghi’s announcement that the ECB is highly likely to increase accommodation at its March meeting.

But, for the euro, a substantial amount of expansion in accommodation is already priced in and the ECB will struggle to hurt the EUR in our opinion.

Therefore, it seems the pound has more to lose in the pair.

Latest Pound/Euro Exchange Rates

United-Kingdom European-sUnion
Live:

1.132▼ -0.25%

12 Month Best:

1.2188

*Your Bank's Retail Rate

 

1.0935 - 1.0981

**Independent Specialist

* Bank rates according to latest IMTI data.

** RationalFX dealing desk quotation.

 

The Roller Coaster is Just Warming Up

Of late ING's Viraj Patel has been arguing that markets have yet to truly account for the cost of the UK leaving the EU, with GBP’s plight predominantly a function of the benign global risk environment and a dovish repricing of the BoE’s hiking cycle.

"The role of Brexit in steering recent GBP price action can be likened to a roller coaster warming up with some small twist and turns before an inevitable sharp drop," says Patel.

ING's short-term financial models show that even after today’s sharp move lower, only a 1.5-2.0% risk premium is priced into GBP/USD.

Moreover, other UK asset markets are yet to be trading with any meaningful discount, while UK activity data is also likely to show signs of a temporary slowdown over the coming months.

"Hence, there are still valid reasons why the UK’s in-out referendum poses further downside risks to GBP," warns Patel.

Major Technical Obstacles Could Slow Declines

All is not lost for the pound with the charts confiming there are important support zones ahead.

In many ways the GBP/EUR chart reflects this downside bias in the pair as it remains in a medium-term down-trend.

However, there are major obstacles preventing bears from pushing the rate lower.

The pair has reached substantial support from the 200-week MA.

It has also reached the minimum target calculated using the height of the pattern extrapolated below the neckline at roughly 1.2700.

Therefore, there is a possibility of either a bounce or sideways consolidation at the current level.

If, however, there is a deeper penetration below the 200-week MA and the 1.2500 level, that might provide confirmation for an extension down to 1.2310.

GBPEUR19

On the daily chart GBP/EUR is falling inside a descending channel.

It has reached support from the 200-day and is currently consolidating, in what might be a triangle formation.

If the triangle breaks lows and moves below the 1.2670 lows that would confirm more downside, howeve, the 200-week MA at 1.2635 would be expected to check down-side momentum and preventer a deeper penetration. 

A break higher would not suffer the same restrictions, and so a move above 1.3052 would probably reach 1.3150, just below where the 50-day MA is situated, and likely to produce tough resistance.

But, a Weaker Pound is Also Good News

We often betray a bias that a stronger currency is better; indeed it is for those buying foreign assets, but what about the impact of the pound’s fall on other parts of the economy?

BoE Governor Carney told the Treasury Select Committee on Tuesday that a weaker GBP could offset UK’s economic frailties and help boost inflation. 

Carmey adds the BoE is not making any judgment on the outcome of Brexit vote. As we have noted here though, the appearance of Carney and other BoE members before the Treasury Select Committee was undoubtedly negative for sterling.

The bottom line? There is a reason central bankers like a weaker currency as it tends to stimulate the economy.

"In one sense, it is worrying if it indicates that foreigners are starting to shun UK assets, given the UK’s big current account deficit. If investors start demanding a higher return to hold UK assets, this could hit domestic demand," says Capital Economics' Redwood who has briefed clients on what the moves in sterling mean for the UK economy.

Indeed, MPC member Gertjan Vlieghe pointed out to the Treasury Committee on Tuesday that the pound’s fall could be a warning sign that business and consumer sentiment will also fall due to the referendum.

"However, the pound’s drop is not all bad. We have argued for some time that a lower exchange rate is necessary to rebalance the UK’s economy," says Redwood.

The economist points out that following its fall in 2009/10 – to a level generally thought necessary to rebalance the economy – the pound subsequently reversed much of this drop, appreciating by over 20% between March 2013 and August 2015.

"So a lower pound is probably one of the more preferable ways for Brexit concerns to have affected the UK. Admittedly, corporate bond spreads have risen quite sharply, but they have elsewhere too. And UK equities don’t seem to be underperforming, while the spread between gilt yields and OIS rates has risen only modestly," says Redwood.

Mid-Week Market Brief

Yesterday's dip in risk sentiment spilled over into the far east, pushing Asian equity markets lower overnight.

Following comments from the Saudi oil minister that they would not cut oil production, oil prices slid further as inventory data showed a sizeable increase in US crude stockpiles over the past week.

Meanwhile, comments from US Fed vice-chair Fischer noted that it was too early to judge the impact of the increase in market volatility.

However, Kansas City Fed President George suggested that the March policy meeting was a ‘live meeting’.