Westminster’s noise fails to deflect pound’s steady trading range
THE mystery is why sterling has not yet crashed. The pound remains in the middle of its 13-month trading range against the euro. It has largely shrugged off the tempestuous events in Westminster.
Currency strategists in the City are masters of political risk. They make – or lose – large sums by taking the pulse of democracies. They filter out media noise. It is revealing that they are not yet willing to pull the trigger.
Jordan Rochester, from Nomura, says global funds and big money investors mostly discount “no-deal” talk as bluster, betting that Parliament will impose a settlement of sorts in the end. Bargain hunters are on the prowl. “There are a lot of people out there looking for a buying opportunity for sterling,” he said.
“Most of the questions we are getting from clients are about the parliamentary process: whether there will be another referendum, or a revocation of Article 50. They are not asking us about a ‘no-deal’ because they don’t think it exists as a practical possibility,” he said.
Sterling slipped after the resignations of Dominic Raab and Esther Mcvey, when it looked as if the dam was breaking. It has bounced up and down on every headline over the Tory leadership challenge.
Nevertheless, the pound is still stuck in a long-term band of €1.12 to €1.14 against the euro, the relevant exchange rate for Brexit risk. The dollar moves to a different rhythm, largely reflecting shifts in policy by the US Federal Reserve.
Sterling was 3pc lower at one point in August than it is today, and was 7pc lower after the Conservative Party conference in October 2017 when it fell below €1.06.
“The pound is simultaneously high and low,” said TS Lombard, likening the Brexit conundrum to “Schrodinger’s cat” – a concept borrowed from quantum mechanics. “The current price of sterling on your screens can be characterised as the superposition of all possible Brexit end states.”
TSL’S Christopher Granville says sterling would crash 20pc in a Brexit bust-up, but is more likely to rise by 10pc when the opera buffa in Parliament is over and people discover that Theresa May is still there and that nothing has really changed. Britain will still be in the EU in all but name for years to come. Such asymmetric forms of risk are very hard for markets to trade. Investors already have large net “short”
positions on sterling. This has buffered the shock of political events over recent days. It has been a different story for Uk-linked equities and for the bond market, where funds betting on interest rate rises were caught off-guard by the political storm. Gilt yields have fallen following a flight to safety.
Adam Cole, from RBC Capital Markets, says currency investors are faced with growing “fat tail risks” on sterling in both directions. Westminster fever could cause the pound to plummet but it could also cause it to rocket, and the latter of these two opposite outcomes is more probable.
“The risk of defaulting to no-deal exit if the Bill fails in the Commons rises with every Tory resignation. But as that risk grows, the pressure for a second referendum – either to force the hand of Conservative rebels or to resolve the mess that results – also grows,” he said.
“We think the upside ‘tail’ has fattened more than the downside,” he said. RBC expects a 10pc jump in sterling against the dollar if there is a second referendum, and a 12pc fall in a no-deal outcome. Mr Cole said it is one thing for Tory Brexiteers to precipitate a leadership contest, quite another to succeed in ousting the Prime Minister. Traders should look beyond any knee-jerk sell-off in sterling over coming days. “Given that a large majority of Conservative MPS are pro-remain, it is highly unlikely a majority would vote her out,” he said.
Of course, this may be the calm before the storm. Hans Redeker, from Morgan Stanley, says hedge funds are watching the August low of $1.2665 against the dollar (currently $1.2875), a key support level for technical chartists.
If it breaks through that line, it could fall hard.
The Morgan Stanley view is that sterling is 15pc undervalued against the dollar and is likely to surge once the dust settles, propelled by a pent-up investment boom. But it is a double-edged scenario.
“The history of sterling is that when it moves, it really moves,” said Simon Derrick from BNY Mellon.
Data from the currency options market show peak hedging in the run-up to the new year.
The currency could buckle in December. Flow data from BNY’S €30 trillion custody holdings for central banks, wealth funds, and pension funds, have been flashing warning signals since the late summer.
“We’re seeing caution on sterling, but we are also seeing the same thing on flows into the euro. It is the Italy story,” he said
One theory doing the rounds is that it may take two votes in Parliament to push through the May-barnier deal, much like the $700bn “TARP” rescue for the US economy after the Lehman bankruptcy in September 2008. Congress narrowly rejected that Bill at first. Wall Street promptly crashed 7pc. A seriously rattled House passed the measure days later.
A sterling meltdown might concentrate minds in much the same way. Tory rebels would come under enormous pressure to restore stability. So would Labour, given that Europe’s leaders would be cheering on the deal and warning that the text was closed.
But the TARP parallel ultimately breaks down. That episode was about money. Brexit is about the British constitution and the elemental question of who governs the country. Chalk and cheese.