With the prospect of a 'hard Brexit' becoming a reality, investors
who were previously expecting a 'soft' Brexit, or no Brexit at all, have
updated their priors, and Sterling has depreciated about 5 percent over
the space of a week against G10 currencies. GBP/$ is about 1.5 percent above 1.20, which is our 3-months forecast published on 5 July 2016.
We quantify the magnitude of a potential further fall in the Pound.
Based on our benchmark model that assesses the impact of political
uncertainty on currencies, the cumulative depreciation of Cable could be
as large as 25 percent by year-end, an additional 7 percent decline from its current value.
While this estimate is subject to the usual degree of model uncertainty and should be viewed with a degree of caution, the
following additional considerations lead us to think that such a
downside move in Sterling is quite likely to materialize over the next
couple of months.
difficulties and hostilities around the process of negotiating Brexit
have come to the forefront in the past week, in our view, the negative
news has not yet been fully reflected in FX.
we expect data to deteriorate over the next year, surprising more to
the downside than it has done so far, also weighing negatively on the
expect that monetary and fiscal policy will continue to place more
weight on economic activity than on inflation; hence, policy news will
be at worst neutral and at best negative for the currency.
repricing of a policy rate hike in December by the Fed and the USD
strength associated with it can also contribute to Cable downside.
the current juncture, we continue to think that, despite the large
current account deficit, the UK will not face a balance of payments
crisis of the type seen in emerging markets. A sudden stop of capital
inflows forcing a much larger devaluation of the currency is unlikely,
as long as the UK's rule of law and institutions remain stable and
business friendly. That said, even without a balance of payments crisis,
we show below that there have been eight episodes in the UK where the
currency depreciated by 25 percent or more over a period of less than a
year, even though in many of these cases the exchange rate regime was
either fixed or pegged, and the UK government either moved to a flexible
regime or announced a one-off devaluation.