HomeContributorsFundamental AnalysisAs BoE Takes Hawkish Turn, Brexit Risks Come Back to Haunt Sterling

As BoE Takes Hawkish Turn, Brexit Risks Come Back to Haunt Sterling

After starting 2017 around $1.22 – levels last seen in the 1980s – few would have believed that the British pound would end the year at $1.35. The currency’s gains didn’t stop there as cable went on to top the 1.43 level in January for the first time since the day after the Brexit referendum on June 23, 2016. However, renewed Brexit concerns have since pulled the pound back to around $1.38 even as the Bank of England flags an earlier-than-anticipated rate hike.

While the weakness of the US dollar certainly gave sterling a hand up during 2017, a better-than-expected performance of the British economy has also contributed to net speculative positions in the pound turning long in October for the first time in two years. The Bank of England has been quick to acknowledge the economy’s resilience in the face of the Brexit uncertainty. Last week, the Bank upgraded its forecasts for both growth and inflation for 2018 and 2019 in its February inflation report, saying that "monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November Report".

However, despite the British economy managing to stave off a recession, growth is lagging those of other advanced economies, notably the Eurozone and the United States, leading some to question the BoE’s stance. In addition, although an agreement between the UK and the EU on the Brexit divorce terms in December did add some much-needed positive momentum to the negotiations, downside risks are far from having abated. The EU’s chief negotiator, Michel Barnier, reminded investors on Friday that more bumps lie ahead on the journey to a final Brexit deal as he warned the UK that an agreement on a transition period was "not a given" due to ongoing differences between the two sides.

Sterling slid to a 3-week low of $1.3763 after Barnier’s comments, which come amid fresh criticism of the Prime Minister, Theresa May’s Brexit strategy by both the public and members of her own party, fuelling yet again talk of a leadership challenge. The BoE’s own projections are based on the assumption of the UK and the EU striking a post-Brexit trade deal, so any fresh setback in the negotiations would likely prompt a revision of those forecasts, and in turn on the expected path of interest rates.

Currently, markets are pricing in a full 25 basis point rate hike by August, earlier than November that was being predicted just a few weeks ago. Some analysts have brought forward their expectations of a rate hike even earlier to May, though markets aren’t fully convinced, with the odds standing around 65%.

In the event of the UK and the EU missing the March deadline to strike a deal on a transition period by the end of March, a May rate hike would become even less likely. But should an agreement be reached, it would remove a major layer of uncertainty for British businesses and could boost confidence in the short term. The Bank of England would feel far more confident to raise rates under such circumstances and could decide to move as early as May.

Sterling could also garner support in the coming weeks from a series of six speeches by senior UK politicians, including the prime minister, outlining the "Road to Brexit" as it has been dubbed. Previous keynote speeches delivered by May on Brexit had a tendency to boost the pound as they provided clarity to investors about the government’s plans.

The Foreign Secretary, Boris Johnson will kick off the latest round of charm offensive with a speech on Wednesday. It will be followed by a speech on the future security relationship between the UK and the EU by May on Saturday in Munich, Germany, with speeches by the Brexit Secretary David Davis, the Trade Secretary Liam Fox and the Cabinet Office Minister David Lidington to come in the week after. Mrs. May will give a second and final address, detailing the future partnership the UK is seeking with the EU, the date of which has yet to be announced. This will likely be the highlight of the series, and if all goes well and the talks proceed to the future trade relationship in March, the pound could target $1.45, as such an outcome would raise the prospect of two rate hikes by the BoE over the next year.

But with many contentious details still to be worked out, including aspects of the divorce terms such as the Northern Irish border that have yet to be resolved, a delay in reaching a transition deal as well as protracted trade talks are a strong possibility. A prolonged period of uncertainty would be bad for the British economy and could send sterling into reverse. The pound should be able to halt any sharp decline in the $1.35-1.36 area were the negotiations to run into trouble. A major setback though could push the currency further down towards the key $1.30 level.

Sterling could become especially vulnerable in a scenario where negative developments in the Brexit negotiations coincide with a strengthening US dollar. The pound’s recent gains are already looking unjustified when looking at the yield spread between 10-year UK gilts and US Treasury notes, which has been falling since September 2017, while cable has been rising. If as expected, US growth accelerates further over the coming quarters but UK growth picks up only marginally, the declining spread could be the trigger for a major correction.

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