Analysts at HSBC have released their Brexometer - a model that allows them to gauge where the Pound will land in the event of a hard or soft Brexit.
The metric uses the GBP/USD exchange rate as an indicator of the severity of Brexit being priced by markets.
“Now we use GBP to gauge where we are in the battle between hard and soft – this is the HSBC Brexometer,” says HSBC’s David Bloom.
A zero reading on the Brexometer signals the UK remaining within the EU.
A 100 reading indicates a “diamond-hard Brexit” in which the UK would completely sever all links with the continent, including the common market, the EU budget and free movement of labour.
HSBC say an exchange rate of 1.55 reflects a zero reading on Brexometer, whilst GBP/USD at 1.10 would equal a 100 reading.
The current exchange rate in the 1.21s reflects a reading of 74 on the Brexometer which is “just beyond the borderline of a Hard Brexit,” explains Bloom.
The Brexometer has three broad ranges which are commensurate with three different types of Brexit scenario.
These are they:
0 - 33: Nearly no Brexit.
UK adopts a Norway or Switzerland style arrangement with the EU.
34 - 66: Soft Brexit.
This would mean a Brexit with “some sort of trade agreement” intact.
67 - 100: Hard Brexit.
“Anything over 66 suggests a relatively hard Brexit is being priced in by markets,” says Bloom. “This may mean little in the way of agreement on trade, investment and immigration, and is associated with Cable trading between 1.10 and 1.25."
HSBC have used two main valuation methods to calibrate their Brexometer.
The first is based on interest rate differentials.
Interest rates are a major currency driver.
In the global financial markets capital flows from low interest jurisdictions to higher interest rate jurisdictions.
This heavily influences the demand and supply of currencies.
The flow is always from the lower interest rate country to the higher as investors seek a bigger return on their money.
The difference between the interest rates is one way of estimating the value of an exchange rate.
For GBP/USD this results in a rate of between 1.50 and 1.55.
This means taking away the weakness caused by Brexit and using only the interest rate differential would probably make the exchange rate 1.50-55.
This is why Brexometer at zero equals 1.55.
Another method of estimating the ‘true’ or ‘fair’ value of a currency is by using what HSBC call their Little Mac method.
This is based on PPP or Purchasing Power Parity.
This is the theory that the exchange rate can be determined by comparing the cost of a basket of identical goods in both countries.
The exchange rate is determined as the rate at which they are worth the same amount.
So, if a basket of 10 common goods in England cost £20 and the same or near -as goods in the US came to $30, the exchange rate would make them equal the same amount.
Thus GBP/USD would be 30/20, which would equal 1.5.
According to HSBC’s Little Mac method the exchange rate should be between 1.52-1.62, and so their 1.55, for no Brexit is about right as it falls within this range.