Why the British pound’s resilience may be short-lived

The UK’s no-deal Brexit threat is designed to get concessions out of the EU, say traders

If the British government opts for a no-deal Brexit, the pound could be in for a nasty surprise before the year is out, setting the scene for a decline that would dwarf its recent losses. Photo: Reem Mohammed / The NationalShow less

The British pound has been on a losing streak in recent days as the likelihood increases that the UK will leave the European Union without a trade agreement. Given the potential disastrous economic consequences of such a fractious departure, the question arises as to why traders haven’t punished sterling even harder.

The answer probably lies in the fault lines that bedevil the pound’s peers. But its resilience may not last.

The UK government said last week that it’s prepared to break international law “in a very specific and limited way”, introducing legislation on Wednesday designed to dodge parts of the EU Withdrawal Agreement relating to trade with Northern Ireland. That’s the kind of political shenanigans that can sink a currency.

But while the pound has duly reversed some of its gains against the dollar after setting a high for the year at the start of this month, it remains higher than its 2019 average and well above the March low.

There are other, less politically charged, reasons why investors might shun sterling. For one thing, the UK economic fundamentals look worse than those of its peers. The record 20.4 per cent contraction in gross domestic product in the second quarter was worse than any other major world economy, and about double the shrinkage suffered in the US and German economies.

Moreover, Chancellor of the Exchequer Rishi Sunak is sticking with his timetable to phase out Britain’s furlough scheme next month, in contrast with European neighbours such as Germany, Italy and France that have extended their programmes to pay the bulk of wages for workers who might otherwise lose their jobs.

Currency speculation, though, is a two-way trade. And there are compelling deterrents for any hedge fund considering shorting sterling and going long of either dollars or euros.

The US currency has been in a downward spiral for most of this year, after benefiting from haven flows in March as the global ramifications of the pandemic first became apparent. With the Federal Reserve perceived to have more firepower to ease monetary conditions than its fellow central banks, and the world awash in dollars, the greenback has been the closest thing to a one-way bet in the foreign exchange market for several months.

The UK's record 20.4 per cent contraction in gross domestic product in the second quarter was worse than any other major world economy

The prospect of legal challenges to the legitimacy of the November presidential election – whatever the outcome – is also providing fodder for hesitation among investors who might otherwise favour a revival of fortunes for the US currency. Its modest bounce in the past few days is attributable to comments last week from European Central Bank chief economist Philip Lane, who made a rare verbal intervention after the euro breached $1.20 for the first time in two years.

Now the common currency’s gains are threatening to put the chances of the euro region meeting its inflation target even further out of reach, and the ECB is clearly nervous of further appreciation.

But there’s another potential explanation for sterling’s relative resilience, one with a very different endgame. Traders and investors may still be convinced that the UK’s current stance is all a bluff designed to wring as many concessions out of the EU as possible. No responsible politician, goes this argument, would seriously contemplate quitting the bloc without a trade deal to defend its economy against potentially ruinous consequences.

If the British government believes its own rhetoric that a no-deal departure is a great outcome for the nation, it may blindside sterling holders by carrying out its threat. In which case, the pound could be in for a nasty surprise before the year is out, setting the scene for a decline that would dwarf its recent losses as the economic and political repercussions of a full-strength hard Brexit start to sink in.

Sterling may yet turn out to be the weakest horse in the currency glue factory.