By Elizabeth Belugina, the Head of Analytics Department at FBS
For more than a year Brexit has been tormenting authorities and businesses both in the UK and the European Union. This topic is the constant driver of the currency market, although its effect on the British pound during this time hasn’t always been the same.
Right after the Brexit referendum in June 2016 the pound fell versus the US dollar losing about 20% in 4 months– this decline still hasn’t been erased. Back then the news of Britain’s future divorce with the EU came as a shock for the market and had negative impact on the sterling. Now the framework has changed. It’s widely accepted that Brexit is inevitable.
The longer the terms of Britain’s departure remain unclear, the harder it is for British economy: although William Congreve said that uncertainty and expectation are the joys of life, business would like to get rid of this particular source of trouble. As a result, now the situation turned by 180 degrees: delays to Brexit now hurt the pound.
All eyes on December
The timeline for Brexit has been set: the UK should leave in 16 months – on March 29, 2019. A lot has to be done before this time comes. One of the milestones is the EU summit on December 14-15. According to Donald Tusk, the President of the European Council, Theresa May’s government has to make progress on the Brexit bill and the Irish border issue by the leaders’ meeting in December. If it doesn’t, it will lose a chance to push talks about future trade ties and they could be delayed until next March.
The first stumbling point is the question of money: the exit from the EU is not going to be free. As a member of the EU, Britain signed up to budget payments and other liabilities such as pensions for EU civil servants that stretch into the future.
Europe asked Britain to pay at least 60 billion euros ($71 billion). At the same time, European officials understand that British public will likely be appalled by such amount. The actual divorce fee will likely be between 45 and 55 billion euro. Theresa May’s cabinet is already not at its best: a couple of ministers fell on their faces, and discontent with May herself is increasing.
The second big negotiations issue is the question of the Irish border. Ireland, a member of the EU, is against any kind of border on the island after Brexit as it will remind about the previous years of violence and hurt Irish economy. However, as the UK is leaving the European single market, a policed frontier and customs controls will have to be introduced.
According to Brexit Secretary David Davis, a deal with the European Union is the most likely outcome of talks, although the British government was prepared for no agreement with the bloc. The country’s authorities need to make a significant offer to the EU to convince it that it’s serious about paying what it owes and yet make it OK with the voters.
Will Brexit be hard?
There are two shades of Brexit – a soft one and a hard one. The first option involves Britain staying in the EU single market and customs union. The second option means that these ties will be severed.
As the EU is Britain’s largest export, it’s clear that hurdles to trading with the bloc will hit the UK economy. In addition, a fallout from hard Brexit will include a disruption of industrial supply chains, debasement of London as the global financial center and public-sector issues.
The impending Brexit has already resulted in heightened inflation and government’s borrowing. The research of the Centre for Economic Performance (CEP) shows that every British family loses on average 404 pounds ($534) a year after the Brexit referendum. In other words, higher inflation makes an average worker lose a week’s payment in a year. According to the UK Treasury department, hard Brexit may cost from 38 to 66 billion pounds (47-81 billion dollars).
The government is not standing still. Theresa May has recently announced 4-billion-pound spending on research and development and regional growth strategies, setting out plans to help the economy grow after Brexit. Will this be enough? That is the question.
Impact on the pound
The flow of various statements about Brexit is very intense. This can be very confusing for GBP traders. One day there’s hope, the other day it disappears.
The fate of the pound will depend on how soon the UK and the EU can move on to discussions over their future trading relationship. The British currency will strengthen on any signs of a mutual understanding between the EU and the UK. Hurdles to Brexit will send the pound down.
It’s also necessary to take into account the EU side of things. If German political problems remove Angela Merkel from dealing with Brexit, it will make life for the sterling harder, as another European leader – France – pursues a harder line in the talks.
One has to realize that success of Brexit talks can be only a short- and medium-term driver of the British pound. Provided that December brings fruits of agreement between the sides, year-end targets for GBP/USD are in the area of 1.3600/1.3500. As for the more distant future, the cost of Brexit is still only a subject of guesses, so uncertainty remains. The year of 2018 will be key for the British currency. London and Brussels will have to reach an agreement on trade by October for it to be ratified by all European parliaments before the actual Brexit in March 2019.
In the months ahead, demand for the GBP may decline not only because of concerns about the UK economic future but also as the Bank of England will likely fall behind other regulators in monetary policy tightening. This is already starting to be true. While the Fed raised its policy rate by 1 percentage point in 2 years and the ECB is slowly reducing monthly stimulus, the BOE managed only to withdraw the emergency rate cut made in August 2016. If the UK economic health deteriorates, the central bank may even have once again to resort to rate cuts. It means that from the yield perspective the pound will look less attractive than currencies of the countries where banks are raising rates. The sterling may also suffer against currencies with lower debt. Political issues like the call for new elections will provoke negative reactions in the pound as well.
In these circumstances, a well-known mantra comes to mind: keep calm and trade the GBP as the Forex market allows traders to make money both on increases and declines of this currency.