Are Brexit fears to blame for the plunging pound?

Technology Eye | Feb. 25, 2016

The slumping pound, spurred by the risk of the UK leaving the European Union , has earned the currency a dubious accolade.

Among major currencies , sterling’s loss of more than 5 per cent against the US dollar this year ranks as one of the worst market performances, with only Mexico and Argentina falling further.

After dropping a full 2 per cent on Monday, the biggest one-day decline for the UK currency since October 2009, sterling has continued declining, hitting a low of $1.3965 on Wednesday — its lowest level since 2009. The risk of the UK leaving the EU has dragged sterling into rarely visited territory against the dollar. During the post Bretton-Woods era of freely floating currencies, the $1.40 level has effectively been a floor for the pound.

How does this compare with past bouts of political turmoil? It is big. Last August — which was not a vintage time for global markets — sterling dropped 1.3 per cent in one day.

In the thick of the May 2010 general election its biggest decline was 1.4 per cent.

In the run-up to the Scottish independence referendum in 2014 it fell 1.2 per cent, and that was an event considered troubling enough to have banks buying pizza and laying on blankets for currencies traders on the big night.

So this is right up there in the list of post-crisis bad days for sterling.

Is the fear new? Not really. The risk of the UK dropping out of the EU has been bugging the pound for weeks.

The outline of an agreement between David Cameron, the UK prime minister, and his EU partners on the way forward did nothing to prop sterling up.

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How nervous is the market? Traders are biting into their nail beds. Six-month implied volatility on sterling, a measure of expected volatility in the currency that reflects how much it costs to hedge against large moves, is surging.

Remember: that six-month period easily encompasses the date of the referendum, which is scheduled for June.

The rate stands at a more than two-year high of 12 per cent. This means the market is bracing for a bigger shake-out than around the time of the most recent general election or the Scottish independence referendum.

The prevailing guesstimate on how heavy the blow to sterling could be from a vote to leave is in the region of 15 to 20 per cent.

Why sterling? Why not other UK markets? Stocks do not seem at all troubled for now. If anything, the opposite is true. Government bonds have stumbled but not on the same scale.

Sterling is taking the strain. As UBS says: “The currency is the main barometer of uncertainty.”

There are several reasons for this. A potential hit to UK growth could cause the Bank of England to hold interest rates at rock bottom for even longer than previously thought. If the blow is hard enough, some experts reckon it could even prompt a rate cut.

In addition, the UK runs a reasonably hefty current account deficit. That is not usually a problem, but it does mean that the country needs to keep drawing in its usual inflows to hold the currency steady.

A pause in trade in goods and services, and/or any hesitation in, for example, foreign direct investment while would-be investors think about what Brexit could mean, is bad for the currency.

For bonds the picture is more mixed. Brexit is, on the one hand, a possible reason to avoid UK assets. But it also suggests a need to seek safety, and for many investors gilts fit the bill.

Is it a bad thing? A swooning currency is often seen as a sign of stress. But it is a boon for exporters and a potential blessing for central bankers.

A weaker pound could prop up droopy inflation, assuming upbeat overseas demand for UK goods and services.

In that respect, Brexit fears are succeeding where many a heavy-hitting central banker has failed.

SOURCE: World Economic Forum

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