New lows expected for sterling before Brexit fears settle

The full impact of Britain leaving the European Union has not been priced into the foreign exchange market as yet, because of uncertainty over what comes next. As a result, the pound could dip even lower before participants are convinced the worst is over.

That's the sentiment of panellists at the 13th FX Week USA conference, held at the Metropolitan Club of New York, who said politics will pose a bigger problem than economics for the UK, and they are expecting a forceful response from the EU when the government begins leave talks.

To me, as an investor, we often think about economics, but I think the most important channel of contagion happens to be politics
Marc Chandler, Brown Brothers Harriman

"I share the views [that] sterling still hasn't made a bottom yet, but I am not too pessimistic on the UK economy itself. To me, as an investor, we often think about economics, but I think the most important channel of contagion happens to be politics," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman. "I don't think all the bad news for the UK is priced in yet. What the UK wants is a single market; what they don't want is immigration. They can't be a smorgasbord member of the EU or outside the EU."

Chandler was among a three-member Brexit panel who believe the pound, which has already seen historic lows of around 1.32, could trade down to the lower 1.20s before the market is convinced that all of the Brexit news is known. Some do not expect the currency to return to trading above 1.40.

Current account weak link

There is mounting concern as to how the UK will fare outside the EU. Panellists said the country's £32.7 billion current account deficit – when the value of imports exceeds that of exports – remains a weak link.

"There is a huge question mark about how that current account gets financed," said Daniel Katzive, head of FX strategy for North America at BNP Paribas.

Others argue that Britain's structural problems could further stir the political pot as the country plans to leave a working business model for an uncertain new plan.

"I think this is the problem and the politicians aren't recognising it. That process is yet to unfold and I wouldn't be surprised if, over the next year, you have another round of political uncertainty. Once actual, aggressive negotiations begin there could be more leadership changes. The current account deficit represents maybe the fragility to the UK economy in this fiscal year, but the biggest structural story has been running for 40 years," said Shahab Jalinoos, global head of FX strategy at Credit Suisse.

In an audience poll of more than 200 buy- and sell-side market participants, the overwhelming majority believed voting for Brexit was a bad idea. Moreover, panellists said it was unlikely that UK Prime Minister Theresa May – only the second woman in history to hold that position – will be able to stop Brexit from happening or negotiate an exit in Britain's favour.

"All the cards are held by the EU. It's going to be very difficult for the UK to negotiate what they want when the EU has all the cards... In the big picture, it is going to be EU politics that really matters most and what they are willing to negotiate for, and how important it is to set an example to make sure no other country leaves," said Chandler.

Trust and divorce

Then there is the issue of trust.

"This is a very big, momentous decision for the UK that has far-reaching ramifications. Even if they don't really leave [the EU], imagine if you go home and your spouse tells you they are thinking about a divorce and you don't know if they're going to go through with it or not. That is going to change your attitude," said Chandler. "I think that is what is going to happen with the UK and the EU. Your spouse just told you they want a divorce, but they haven't gone to a lawyer yet; they haven't filled out the papers. You still trust them?"

With the US undergoing a contentious presidential election period, with Republican Donald Trump and Democrat Hillary Clinton heading for a showdown in November, the hope is that the voting public will be more conscientious than their UK counterparts in mitigating any political risks.

"I'm counting on the American people to be smarter than our British colleagues. What I mean by that is I don't think there is going to be much political risk. It's very hard for me to see Trump winning," Chandler said.

The market didn't see Brexit coming either.