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Categorized | Currencies

Pound enjoys respite as Brexit risk looms

Posted on November 29, 2016

A surging US dollar on the foreign exchange market, has encounter one obstacle in the form of pound sterling.

The UK currency has held firm in November, rising nearly 2 per cent versus the dollar and set for its best monthly performance since January 2009.

The Bank of England’s effective exchange rate index, which measures the value of the pound on a trade-weighted basis, is 4.8 per cent higher since the start of November. This comes after the index slumped to an all-time low in October in the wake of the country’s Brexit vote.

The pound’s particularly strong November performance against the euro, up 5.1 per cent, has driven the rebound in the index, given the importance of the single currency bloc as a trading partner. The US, Japan, China and Switzerland are next in terms of importance as trading partners for the UK.

Political risk still the driver of sterling …

The pound’s Brexit convulsions have been on hold in November, while it has been the turn of political risk from beyond the UK to affect sterling — pushing it higher.

Donald Trump’s election victory has changed investor sentiment in a number of markets. Selling sterling was one of the most favoured trades ahead of the US election, and “the Trump effect has reversed all the trends we saw”, according to Bilal Hafeez, FX strategist at Nomura.

With political risk the number one concern of investors, European events are at the centre of attention, beginning with this weekend’s Italian constitutional referendum. Further weakness by the euro against a range of currencies, including the pound cannot be ruled out.

… Don’t ignore the economy …

The dollar’s rise post-election has a bearing on sterling. Adam Cole, G10 FX strategist, says the pound becomes a “mini-dollar” on a dollar rally “primarily because there are such close links between the corporate sectors” through big foreign direct investment flows. “The US and UK cycles tend to be synchronised as a result.”

Meanwhile, the UK economy, which has had varying degrees of influence on sterling since Brexit, is again being noted by investors. Luca Paolini, chief strategist at Pictet Asset Management, says the pound looks cheap, with the exchange rate on a par with “fairly dire economic growth”.

Weak growth may well be the UK’s destiny during Brexit negotiations, Mr Paolini adds, but in the short term the economy and UK assets are more likely to exceed expectations, “which in turn presents potentially attractive investment opportunities”.

… And definitely keep on top of Brexit

Some investors see the UK’s Brexit difficulties in a different light post-Trump. One rationale, says Roger Hallam, currencies chief investment officer at JPMorgan Asset Management, is that the UK’s security expertise could become an important piece of leverage in Brexit negotiations if the European Union has to worry about US Nato commitments.

Investors have also noted a change in tone since the UK’s apparent Hard Brexit position of October, such as increased talk of a transitional Brexit. “The rhetoric has become more nuanced, and it’s not as compelling to be short sterling,” Mr Hallam says.

But the UK’s current account deficit remains a significant problem for many investors, and Brexit is “still a challenging process”, adds Mr Hallam.

The pound’s recovery in perspective

Sterling’s strong November performance cannot mask its five successive months of decline after the vote for Brexit. That period was bookended by Brexit in June, during which the trade-weighted index fell 8 per cent, and the flash crash in October, a month that saw the index decline 4.2 per cent.

From a peak of 87.76 on June 23 to the 73.72 trough of October 17 when it hit its lowest level on record, the index has fallen 16 per cent.

The pound still has a way to go to breach long-term resistance levels against the dollar, although there is a breakthrough against the euro.

Consolidation is the next phase

RBS expects further gains in the final month of the year as real money asset managers shift their sterling bias from selling to a neutral view and speculative trades focused on a weaker pound are squeezed out of the market.

Mr Hafeez is more circumspect. He thinks support for the pound is artificial, while attention on European politics dominates market sentiment. Until the French election and clarity on Brexit legal rulings, sterling will be in “a holding pattern”, he adds.