Summary
The uncertainty surrounding Brexit has reached unprecedented levels, with the risk of a second referendum or another U.K. election no longer seeming as far-fetched as it did previously. Analysts surveyed by Bloomberg see sterling sliding almost 8% to $1.20 in case of a no-deal Brexit. The situation is further complicated by opposition Labour Party plans to vote down Prime Minister Theresa May’s exit agreement with the EU and push for another referendum.
Multiple Brexit Permutations for the Pound
Analysts in the Bloomberg survey see a 23% probability of a no-deal Brexit, slightly up from 20% in a similar poll held in July. The increasing uncertainty is prompting some investors to opt to stay on the sidelines of the market or trade through options, with volatility becoming more expensive as the Brexit deadline grows closer.
"Many clients don’t want to be involved," Rabobank’s head of currency strategy Jane Foley said. "Those that have to, I would advise to be nimble." Even with multiplying Brexit ambiguities, the pound has gained over the past month, which is partly due to dollar weakness. Some investors see this as a sign that the market is still not fully awake to the risks.
Over the summer markets were strangely complacent on Brexit tail risks, both the chance of no deal and the chance of a soft Brexit. The options market is pricing in more risk but still not enough. This suggests "a sizable depreciation of sterling in case of a no-deal Brexit," according to Thu Lan Nguyen, a strategist at Commerzbank AG.
A Sizable Depreciation of Sterling
At its recent annual conference, the opposition Labour Party said it plans to vote down Prime Minister Theresa May’s exit agreement with the EU and push for another national ballot, citing a second plebiscite on Brexit as a way of avoiding a chaotic separation from the bloc. Analysts in the Bloomberg survey see a 23% probability of a no-deal Brexit, slightly up from 20 percent in a similar poll held in July.
The increasing uncertainty is prompting some investors to opt to stay on the sidelines of the market or trade through options. The volatility premium has climbed to 236 basis points over the realized measure last week, the widest since the Brexit vote in June 2016 but still well below extreme levels seen then.
This suggests "a sizable depreciation of sterling in case of a no-deal Brexit that is roughly 10% as an initial reaction," according to Thu Lan Nguyen. At the annual conference of the U.K.’s ruling Conservative Party, former Foreign Secretary Boris Johnson won cheers with an attack on May’s Brexit plan but stopped short of calling for her to be removed as prime minister.
A Mess of a Situation
The prime minister is preparing to make a significant new offer to the EU – including compromises on the contentious Irish border issue – in an attempt to open the door to a deal, according to a senior British government official. If Theresa May does back down then there’s a high risk of a revolt in her party. It looks increasingly likely that the opposition will push for another referendum.
"In short, it’s a mess," said Michael Riddell, a U.K. portfolio manager at Allianz (DE:ALVG). The opposition Labour Party is pushing for another national ballot on Brexit as part of an effort to block May’s revised deal with the EU, according to Bloomberg.
The Probability of No Deal
In July, participants in the Bloomberg survey saw a 20% probability of a no-deal Brexit. This has edged up to 23%. "Obviously, the risk of no deal has gone up but for me that’s standard for the course of EU negotiations," said Kenneth Broux, a strategist at Societe Generale (PA:SOGN) SA.
Where Would the Pound Go
If Britain tumbles out of the EU without a deal, the pound "plummets to historic lows close to $1.10," according to Neil Jones, head of hedge fund sales at Mizuho Bank RBC’s Cole sees the currency sliding "10% immediately and 15% in the longer run." If no deal meant that there was a second referendum, and if the polls pointed to a remain vote, the pound would rally.
"Of course any further Brexit uncertainty will cause GBP to sell-off," Mizuho Bank’s Neil Jones told Bloomberg according to Reuters. RBC’s Adam Cole sees the currency sliding "10% immediately and 15% in the longer run." If no deal meant that there was a second referendum and if the polls pointed to a remain vote, the pound would rally, according to Rabobank’s Foley.
A No-Deal Brexit: What Now?
As time elapses without an agreement reached by Britain and the EU it is becoming increasingly likely that both will end up in a chaotic situation with no deal and leave their countries reeling. While some experts say a no-deal Brexit could happen as soon as early next year there are others who see a probability of 50% or less.
RBC’s Cole also mentioned that he expected sterling to sell off quickly but rebound significantly once trade talks come back on track saying “The thing you never know with Brexit is the timing – but if I have to put my hand up and say what do I think will happen, I think there’ll be a deal before March 29,”. "Obviously it won’t be as good as it would have been without no-deal possibility but we will get trade talks reopened,” said Broux from Societe Generale.
The Options Market
While most experts agree on what will happen to the pound in the case of a no-deal Brexit not all agree on how high or low it might fall. This raises questions about an options market which investors like those quoted by Bloomberg who see sterling falling below $1.20 for the first time.
At its recent annual conference, the opposition Labour Party said it plans to vote down Prime Minister Theresa May’s exit agreement with the EU and push for another national ballot, citing a second plebiscite on Brexit as a way of avoiding a chaotic separation from the bloc. Analysts in the Bloomberg survey see a 23% probability of a no-deal Brexit, slightly up from 20 percent in a similar poll held in July.
Volatility Premium
The volatility premium has climbed to 236 basis points over the realized measure last week, the widest since the Brexit vote in June 2016 but still well below extreme levels seen then. This suggests a sizeable depreciation of sterling in case of a no-deal Brexit that is roughly 10% as an initial reaction.
Conclusion
The unpredictability surrounding Britain’s exit from the EU has left investors bracing for various possible outcomes – including those they had previously believed to be far-fetched, such as another national ballot. The situation seems increasingly complicated by opposition Labour Party plans to vote down Prime Minister Theresa May’s exit agreement with the EU.
The multiple Brexit permutations on offer are keeping sterling sellers at bay and may even trigger a rally in the currency if there was a second referendum on whether Britain should remain in or leave the EU – that could result in polls pointing to a Remain vote. As the pound has gained over the past month, which is partly due to dollar weakness.
Sterling’s near-term volatility appears well-contained for now but may rise as Brexit uncertainty weighs heavily on investors minds. RBC’s Cole expects "a 10% immediate reaction and maybe as much as15% in the longer run". As of today’s date sterling price has already slumped against nearly all major currencies.
In conclusion with the increasing uncertainty weighing on sterling it is better to be prepared for worst-case scenarios in case Britain does leave without a deal.
