Trading The British Pound Around Brexit News
The British pound (symbol: GBP) has been the most volatile developed market currency since the June 2016 Brexit referendum. As you would expect, this has been due to the uncertainty regarding the UK’s future economic relationship with the EU and other major trading partners after its presumed forthcoming departure from the bloc. Here we’ll take a look at Brexit pound trading on a fundamental level.
As day traders, staying abreast of fundamental news is usually on the backburner. Some technical traders don’t care about the news at all because they trade only on technical analysis. However, in the long-run, asset prices move based on economic influences. Even at the daily level this is relevant. Technical analysis is one part of the toolkit, but here we focus on fundamental factors.
The Current State of the British Pound
Since last hitting 1.50 to the USD during the day of the referendum, the pound has held a range between 1.20 and 1.44.
The “deal or no deal” situation with Brexit is about even, perhaps skewed slightly toward “deal”. There is more upside to the pound than downside.
A hard “no deal” situation seems pretty unlikely due to the impact a disruption in goods imports and exports and travel delays would have on UK GDP. The prospect of UK GDP dropping by 0.5% per annum over the next decade-plus would drop the pound about 10% to around 1.20 or just below. This would occur due to a re-rating in the prices of UK financial assets and a lowering of interest rates. This would cause pound-denominated assets to become less attractive.
If you get a temporary “no deal” the GBP would drop. This would be some type of agreement where the UK agrees to pay something to Brussels for a transition period. It could also allow an extension of the 29 March 2019 deadline to allow for further negotiation.
Any fall in the pound under these developments would likely make it a quality long trade because it would be expected that the currency would stabilize and recover. The main risk to the pound is a failure to establish any trade agreement between the UK and EU, effectively leaving the UK isolated, which would have profound economic effects. This is nonetheless very unlikely.
If you get a Withdrawal Bill and trade agreement in place – i.e., UK still part of Single Market (perhaps for not only goods, but services and labour as well) – with the transition agreement in place until December 2020, this would end the associated “cliff” anxiety.
Accordingly, you’ll likely get a rally up to about 1.45 versus the dollar and 1.33 against the euro.
If there’s a second referendum – albeit quite unlikely – you’ll get 1.50 or above versus the dollar and up toward 1.40 versus the euro. This could take the form of a general election with the opposition Labour Party campaigning on the platform of “Remain” with pressure to introduce a second referendum.
Many polls suggest that UK residents would choose to remain if another referendum were to be held. This is only natural considering that changes in the status quo normally introduce short-run costs that can be painful, inconvenient, and introduce a bevy of negative headlines.
The General Strategy of Brexit Pound Trading
On fundamental factors alone, the pound at 1.30 to the US dollar is slightly cheap. Any “no deal” scenario will cause the pound to dip back into the 1.20’s. However, a “deal” scenario will put it at around 1.45 or higher. This means the reward/risk trade-off probably favours being long the pound relative to the dollar just off considerations of the pound-specific factors themselves.
In terms of the dollar side of the trade – if you are trading the pound against the dollar – the USD has had a strong 2018. But this momentum is fading. The US is in the latter half of the strongest rate hiking cycle of any developed market central bank. It is also reducing its bond holdings, which removes liquidity from the financial system. This makes dollars scarcer and increases the cost of borrowing in them, holding all else equal.
However, currency prices are not just about interest rates, as important as they are. The US is facing protracted fiscal and current account deficits. This leads to a funding gap and fiscal imbalance. Over the long-run and holding all else equal, to cover these gaps, countries need their currencies to weaken. This allows them to more easily pay off their debts and increase exports or decrease imports to cover these deficits. When currencies weaken, exports become more attractive to the rest of the world. Likewise, importing becomes more attractive when the currency is relatively strong because a more valuable currency can effectively purchase more goods and services.
In the US, the positive economic outcomes of the tax cuts and deregulation will turn in the other direction starting in 2020, and begin to be a drag on the US economy. The positive productivity outcomes will start to fade but the borrowing will keep going, exacerbating the US fiscal deficits. As a matter of macroeconomic accounting, the US government can’t keep issuing debt at an increasing pace while keeping up business investment without the trade deficit expanding.
As a result, there is the short-term cyclical boost for the dollar being weighed against by the long-term reality of the US fiscal and current account deficits, which are a drag. Hence the dollar is likely to weaken starting in the next 1-2 years out, particularly against gold.
A “no deal” Brexit scenario would be bearish for the pound. If temporary, the pound would be expected to decline, but snap back. In the unlikely scenario where there is no deal altogether and no proposed deal in sight, this would be especially bearish. However, policymakers should fear the economic consequences of this and be especially motivated to avoid cliff anxiety.
A “deal” Brexit scenario would be bullish for the pound and would likely result in a move back to 1.45+ for the pound against the dollar.
Fundamentally, in the years ahead, the dollar is expected to weaken as the Federal Reserve’s rate hiking cycle and balance sheet tapering stops. The US will start to face the financial reality of fiscal and current account deficits that are beginning to increasingly strain the country’s finances and become a drag on growth.