After two days of sharp losses during the early part of the week, the pound actually rallied slightly when it became clear that a leadership challenge to prime minister Theresa May was underway in the United Kingdom. This can probably be put down to the forex market's wish for greater certainty about the direction of the UK government, over Brexit itself, but also if only to have a prime minister who inspires greater confidence.
The market will probably be inclined to give almost whoever replaces Theresa May the benefit of the doubt, at least for a short amount of time. This is because Mrs May is so tarnished and associated with the stumbling Brexit negotiations of the last two years that she is viewed as almost incapable of offering original ideas on the issue. Hers is the agreement that satisfies hardly anybody, and yet she declares it is the only option available. Whether correct or not, the markets and probably the British electorate want to think that something more inventive might be tried.
Mrs May’s departure will not be mourned by the pound, and arguably it could rally some more if her replacement is prepared to look at the Brexit possibilities with more imagination. This may not necessarily require that a new deal with the EU is produced, as this looks almost impossible, but it does require a better articulation of the alternatives especially if the May deal is eventually defeated.
Clearly the pound would benefit from the thought that a different leader might be able to persuade parliament to back what is on offer. Briefly this might be its first response to a new leader, but at some point reality is likely to dawn that this is a virtual impossibility.
Mrs May’s departure might open the way for a second referendum, which she has adamantly opposed. However, this is also an option that could provide some grounds for a sterling recovery. Obviously, the sustainability of that recovery over the medium term would crucially depend on what a second referendum would ask, and ultimately what the public decides. Even if the date of Brexit is just delayed, the markets may take some heart from the possibility that alternative arrangements might be made in the additional time provided, especially if a no-deal Brexit is the eventual outcome.
Mrs May’s government appears to have made little effort to prepare for a no-deal Brexit, and has actually fanned fears about it through the scenario testing done at the Treasury, aided and abetted by the Bank of England. In the end it may still be that Brexit happens without a deal, and while this move into the unknown would invariably create some instability and confusion, causing the pound to lose ground, a more positive narrative about the opportunities arising from it might serve to limit the downside.
If another leader can emerge that can articulate a greater sense of purpose and self-confidence about the possibilities that Brexit offers - through the promotion of open markets, competitive taxes and regulations - such a message could provide a counterbalance to the negative forces pushing ‘project fear’. This may not prevent the pound from making further losses, but it may restrict them and cause any renewed decline to be perceived as a buying opportunity.
Put another way, a reprieve for Theresa May would probably see the pound’s limited reprieve run out of steam quite fast. It would reinforce the likelihood of the UK exiting from the EU not only without a deal, but without a constructive voice about what happens next and about what ‘crashing out’ might entail.
With Theresa May at the helm, the forex market has been progressing fairly consistently in recent months towards a renewed date with the lows seen after the referendum in 2016, below 1.20 to the dollar. Should she manage to hold onto power, the markets may accelerate the process of sterling reaching this level. Another leader on the other hand might give them a pause for thought.
Tim Fox is chief economist and head of research at Emirates NBD