It’s proving to be a torrid summer for sterling.
From hitting a post-referendum peak of $1.4376 on 17 April, the pound has hit the skids on the foreign exchange markets, plunging earlier today to $1.2840 – a level not seen since 25 August last year – before recovering slightly.
Against the euro, sterling has fared little better, sinking earlier today to €1.1071 – a level not seen since 12 October last year – before rallying modestly.
The explanation being offered by market participants is that this is because, after assuming for a year or so that the UK and the EU would reach some kind of trading agreement post-Brexit, the market is now beginning to think seriously about the possibility of a “no deal” Brexit.
Two events, in particular, have concentrated minds. The first was the warning last Friday from Mark Carney, the Bank of England governor, that the possibility of a no deal Brexit was “uncomfortably high at this point”.
The second was the interview given to the Sunday Times last weekend by Liam Fox, the secretary of state for international trade, in which he said the intransigence of the European Commission was “pushing us toward no deal”.
Most players in the FX (currency) markets still assume a trade deal is likely between the UK and the EU.
But opinions are starting to shift. A Reuters survey of economists, published on Thursday, found they now price in a 25% likelihood of a no deal Brexit – up from 20% in an identical poll last month.
A no deal Brexit has also overtaken the UK joining the European Economic Area – the so-called “Norway option” – as the second-most likely scenario predicted by economists, although a free trade deal between the UK and EU is still considered by most to be the likeliest outcome.
Whatever your views on the UK’s long-term prospects post-Brexit – and there is a sizeable body of opinion in the City that remains optimistic – a no deal Brexit is generally regarded as likely to cause a short-term hit to economic growth because of the potential disruption.
Adding to the depressed sentiment surrounding the pound has been hedging activity by some businesses.
Activity in the derivatives markets in recent days suggests businesses are seeking to protect themselves against further falls in the pound during coming months and into 2019 by buying sterling “put” options. These products give the buyer the right, but not the obligation, to sell sterling at a predetermined price at a future date.
A weaker pound will have all kinds of consequences for the economy.
It is great news for exporters, on the whole, although those whose input costs – such as raw materials – are priced in US dollars or euros may only partially agree.
Britons going on holiday to eurozone countries or the US this summer will have found their pound buys them less than it did.
Most importantly, a weaker pound pushes up the price of imported goods, something that – with the UK’s large trade deficit in goods – will inevitably feed through into higher inflation.
The weakness of sterling against the US dollar, in particular, means that motorists are paying more at the petrol pumps regardless of the crude price (which since 22 May, when Brent last traded at $80 a barrel, has fallen by 10%) because oil is priced in dollars.
With the focus on sterling, there is another dimension to this story that is not getting nearly as much attention, which is the strength of the dollar. The US economy, as shown by last week’s stellar growth figures, is motoring.
The US dollar performed exceptionally strongly during the first half of 2018, notching up gains against most of the “G10” group of the world’s most-traded currencies, falling only against the yen and the Norwegian krone.
The drop in the pound against the US dollar has been exacerbated by the strength of the latter, as shown by the fact that, while sterling has fallen by more than 10% against the greenback since early April, it has fallen by 8% against the Swiss franc and the Canadian dollar, by 7% against the yen, by 6% against the Australian dollar and by only 5% against the euro.
Sterling’s relatively modest decline against the latter, in particular, reflects the fact that, while the pound is perceived to be at risk should there be a no deal Brexit, the EU’s economies would also be hurt.
That suspicion is reinforced with a look at how the pound has traded since its spring peaks against the currencies of other EU members that are not in the Eurozone. Against the Swedish krona and the Polish zloty, sterling has fallen by just 4% in that period, while against the Danish krone, the Slovak koruna and the Czech koruna, it is down by less than 4%.
The danger for the pound is that, to judge by recent activity in the derivatives market, it may have further to fall.
By some measures, speculative “short” interest against the pound is at its strongest for at least five years.
Further weakness would create a serious problem for the Bank of England which, while having made clear it is trying to “normalise” interest rates a decade on from the financial crisis, is keen to raise the cost of borrowing only very slowly.
Further drops in the pound, raising the risk of a surge in imported inflation, might force it to have to move more quickly at the risk of suffocating growth.
However, there are also plenty of people in the market who think that sterling’s recent fall has been overdone, with a no deal Brexit largely priced in already.
There isn’t that much hard evidence that a no deal Brexit has become more likely, other than the comments from Messrs Carney and Fox, making some kind of rebound possible if the news flow in the autumn points towards some kind of trade deal.