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Pound Sterling on a Knife-Edge as Hard Brexit Camp Reach "Put up, or Shut up" Moment

- Scope for the Pound Sterling to rebound is limited says one analyst

- Just as UK data improves, markets might soon shift all focus back to Brexit

- European Council summit at end-June tipped to be a dour affair for Sterling as emphasis falls on October summit

Theresa May at European leaders summit

Above: Theresa May addresses media at a European Council summit. The June event is tipped to disappoint Sterling bulls. Image © European Union, reproduced under CC licensing

Brexit is firmly back in the spotlight for the British Pound, and as a result there are expectations that any strength in the UK currency will be limited while the risks to the downside are seen to be increasing.

Reports out at mid-day confirm Theresa May has given in to her Brexit secretary David Davis over a key point in the administration's Brexit policy.

At stake is a so-called "customs backstop" - a fall-back where the UK and EU agree to maintain existing customs settings in lieu of a decisive agreement being found in Brexit negotiations covering the matter. The need for a fall-back appears increasingly likely considering how fast the October Brexit negotiation deadline is approaching.

At the heart of the matter is the question of how long any backstop would last - it is understood that some factions in the cabinet wanted it to be subject to an open-ended timeline; others including Brexit Secretary David Davis wanted a clear end date.

Rumours have abounded over the past 24 hours that Davis would quit over the matter, leading to the potential for instability in the current administration which would be taken by markets to be a significant negative for Pound Sterling.

Reports out at the time of writing confirm that agreement on the matter has however been reached and no resignations are likely.

But, it appears Theresa May has yielded to Davis and there will in fact be an end date put into the Brexit backstop plan which is to be published later.

Reports say the plan now will include "more detail on the time limited nature".

Sterling doesn't like the news; it has reversed earlier gains and is now lower against the US dollar with the Pound-to-Dollar exchange rate now quoted at 1.3387 having been as high as 1.3471 earlier in the day.

The Pound-to-Euro exchange rate is at 1.1329, having been as high as 1.1393 with the Euro maintaining its charge across the board in light of recent developments concerning future ECB policy.

Brexit has again become an issue for foreign exchange markets following a multi-month hiatus because we are fast approaching a number of deadlines - namely the two summits of the European Council which sees the leaders of Europe assembled to discuss a host of issues, Brexit being one of them.

With the June summit fast approaching, the time for the UK to make big decisions is fast fading, and foreign exchange markets will soon have substantive news on the matter to trade. For now, the issue remains more of a hinderance for Sterling more than anything else, and as has been the case for the past two years, we await clarity on what Brexit will look like.

"We can’t be optimistic about the Pound until we get further clarity on the current issue holding up the negotiations – the plan for the border in Northern Ireland. This plan was supposed to have been passed to the EU yesterday but this did not happen. There are reports that David Davis disagrees with the content of the plan covering the backstop scenario," says Halpenny.

 

June EU Summit Deadline: Expecting Disappointment

The focal points the markets from here will be the June and October summits of European leaders where major decisions are adopted by EU leaders.

The June 28-29 European Council summit had been informally billed as being the next deadline for Brexit negotiations to make progress with a finalisation of Irish border issues and a consensus on the way forward for the future customs relationship being two key objectives.

But, a spokesperson for PM May on Monday, June 5 poured cold water on expectations for significant progress to be reached at the event by stating that the June summit is in fact a “staging post” as the government is working towards reaching a Brexit agreement in October.

"I think that the fact that there is this October summit as sort of second chance means that neither side is willing to make the moves necessary to make this summit a success," says Rupert Harrison, head of cross-asset strategy at Blackrock, in relation to the June meeting and the white paper.

The inference for Sterling of these views is that it will also be a rough few weeks for the Pound as market face up to a dour June European Council summit, and the currency will therefore likely remain pressured given the heavy, circa 15%, 'no-deal' risk premium weighing it down ever since the referendum.

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Furthermore, it became clear on Monday, June 5 that the UK government appears determined to bulldoze aside proposed amendments by the House of Lords to its flagship piece of Brexit legislation - the EU Withdrawl Bill - by pushing the bill through the House of Commons in just one day.

We reflect that markets have taken this as a sign that the move negates the potential for a 'softer Brexit' as the amendments sought by the Lords are widely perceived to have been just that - attempts to keep the UK and EU as closely aligned as possible after Brexit.

The Pound tends to react positively to any indications of close alignment between the UK and EU.

Furthermore, there are risks for Theresa May's government in that any defeats to the bill by rebel Conservative MPs could bring down the government.

This is just the kind of uncertainty Sterling dislikes.

"Brexit uncertainty is set to be a weight on the Pound this month," says Hardman.

 

Markets Shift Focus

Just as UK economic data starts to turn positive for Pound Sterling, the market could soon shift focus away from economics and back to Brexit.

Foreign exchange markets have a knack for placing a greater emphasis on a particular issue for a period of time; importantly the focus can suddenly shift to another issue and the market undergoes a regime shift towards that currency.

In 2017 it was all about Brexit for the Pound, but in early 2018 it's largely been about the economy and the Bank of England; and here the news is getting better as early June has seen a straight flush of consensus-busting economic data that suggests the economy is picking up which certainly bodes well for the UK currency.

The Pound rose sharply against the Euro and Dollar on Tuesday, March 6 as traders responded to the latest IHS Markit services PMI, which showed activity within the UK's largest economic sector rising strongly in May.

May's services PMI came in at 54.0 which, up from 52.8 in April and far ahead of the consensus expectation for a reading of 52.9, marks a continued recovery from the post-referendum low struck back in March when the economy had been hampered by a seasonal slowdown and a period of bad weather. The economy looks set for a second-quarter rebound which should convince the Bank of England to raise interest rates in August.

Sterling certainly needs this better news on the economy: the Pound-to-Dollar exchange rate is now at 1.3367 and therefore lower than where it started the year. The Pound-to-Euro exchange rate is meanwhile stuck in a sideways-orientated rut that is delivering no advantage for either Sterling or the single-currency.

But unfortunately for those wanting a stronger Pound, just as economic data starts to improve, there is a chance that market focus could once more be swinging back to Brexit where the picture is less supportive.

 

Where Could the Pound Go from Here? 

A poll of the world's major financial institutions shows the consensus forecast for the GBP/EUR exchange rate for September 2018 and June 2019 is at 1.1364, which is not too far off current levels and suggests both scope for limited downside and upside.

"We hold a neutral GBP stance as the upside of an eventual rate hike will be limited and the downside of Brexit's full impact (loss of EU single-market passport) will unfold beyond our 12-month forecast," says David A. Meier, at Julius Baer in Zurich.

Consensus forecasts place the GBP/USD exchange rate at 1.38 by September 2018 and 1.41 in June 2019. At present the exchange rate is quoted at 1.3435, so if consensus is correct there is some potential for Sterling gains.

"Ill-timed expansionary fiscal policy is a longer-term headwind for the currency as the global USD supply will rise via a larger budget and external deficit," says David Hokl with Julius Baer. "The USD remains fundamentally overvalued, a headwind for the longer-term outlook."

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