Hard Brexit ‘could lead to £100bn UK bond sell-off ’

Balance-of-payments crisis would send sterling towards parity with dollar, says Bank of America

CENTRAL banks and sovereign wealth funds are likely to dump up to £100bn of UK bonds and precipitate a balanceof-payments crisis if Brexit talks break down in acrimony, Bank of America has warned clients.

The US bank said selling on this scale would send sterling cascading down to lows not seen since the mid-eighties, with a risk of cliff-edge falls if the exchange rate breaks below $1.10.

Kamal Sharma, the bank’s currency strategist, said Britain is dependent on constant inflows of capital to plug the current-account deficit, still 3.9pc of GDP despite improvement over the last two years.

Inflows from foreign direct investment have stalled. Foreign exchange managers – the big beasts of global finance – are the next line of defence. Their behaviour is taking on a critical significance. Mr Sharma says that even a moderate shift in portfolio strategy would be enough to trigger a “protracted current-account crisis” in Britain. There was a short burst of such selling after the referendum in June 2016. Bank of America’s proprietary flow data show central banks quickly carried out the biggest liquidation of sterling assets since their data series began. Buying quickly recovered.

Central banks and sovereign funds hold $500bn (£388bn) of UK debt. The sterling weighting of their reserves is 4.7pc, well above 3.6pc average over the last 20 years. A no-deal scenario could see this revert to mean abruptly.

“If central banks start to question the role of sterling as a reserve currency there will be serious consequences. We could see the pound dropping to $1.05,” said David Owen from Jefferies. There is another shoe to drop. Mr Owen said quantitative easing by the European Central Bank has leaked into British gilts and bonds. This key source of funding for the current-account deficit could dry up as the ECB winds down bond purchases by the end of the year.

Neither Bank of America or Jefferies think a no-deal outcome is likely.

Stephen Jen, a currency expert at Eurizon SLJ, said reserve managers in Asia and other parts of the world would be just as likely to dump the euro if there is a showdown between the EU and Britain. “Brussels needs to think very carefully about trying to punish the UK. It is effectively using the threat of trade sanctions as a weapon. But the extreme disruption for the EU itself if this happens would be greater than some might think,” he said.

Mr Jen, an adviser to Asian sovereign wealth funds, said he doubted whether central banks will in fact run down their sterling holdings, given the lack of good alternatives.

“If you stand back and look at Britain’s ‘CV’, it is actually not bad at all. It has a trusted legal system, a global financial centre, and a lot of soft power. The Bank of England is one of the very few central banks on a normalisation path,” he said.

Bernard Connolly, the European Commission’s former currency director and founder of Connolly Associates, said a weaker pound has already led to a big improvement in the UK’S current account – when adjusted for the jobs boom and full employment, the metric that matters.

“Markets have fits of irrationality but they are not stupid. They would quickly come to the conclusion that the pound has become more attractive,” he said.

“Everybody is primed to think sterling will fall if there is no deal, just as everyone was programmed to think that the stock markets would crash if Donald Trump was elected. Well, they did for about 12 hours, and we know what happened after that,” he said.