The pound is set for more pain if Brexit talks break down

Tourist binoculars offer users the chance to pay in Pounds or Euros in the British overseas territory of Gibraltar, historically claimed by Spain, April 20, 2017.

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Tourist binoculars offer users the chance to pay in Pounds or Euros in the British overseas territory of Gibraltar, historically claimed by Spain, April 20, 2017.
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Reuters/Phil Noble

  • The pound could slump if Brexit talks break down or stall further, according to Capital Economics.
  • Positioning among investors suggests that they’re not expecting anything other than successful talks, which could exacerbate any fall.
  • Sterling has dropped for three consecutive days as disagreements over the Irish border delay progress.

More pain could be on the way for sterling should Brexit talks stall further, according to a note circulated by Capital Economics to clients on Wednesday morning.

“Sterling’s slide against the dollar since Monday afternoon – after a meeting between Prime Minister May and European Commission President Juncker failed to produce a breakthrough in Brexit negotiations – raises the question of how the talks will influence the exchange rate in the coming quarters,” the research house’s daily briefing said.

Investors are not really expecting talks to break down, Capital Economics argues, pointing to the fact that those in the markets “do not appear to be purchasing much protection against a fall in cable in options markets, as demand for out-of-the-money puts relative to demand for out-of-the-money calls is not especially high.”

“This is in contrast to the run-up to the EU referendum when the prospect of a “leave” vote saw relative demand for put options on the exchange rate surge.”

Here’s Capital Economics’ chart illustrating just that:Screen Shot 2017 12 06 at 08.45.15

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Capital Economics

Without having the possibility of a breakdown in Brexit talks priced into their positions, investors could get burned if it does transpire, especially when investors are now net long on sterling – effectively meaning that they’re broadly positive about the pound going forward.

Here’s Capital Economics’ second chart:Screen Shot 2017 12 06 at 08.46.02

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Capital Economics

“This all suggests that sterling might fall quite a bit further if Brexit negotiations were to break down,” the note suggests.

Sterling has had an up and down week so far, swinging wildly between losses and gains as investors try to make sense of the latest developments in the UK and EU’s Brexit negotiations.

Britain’s currency appreciated sharply on Monday after reports that the UK and EU had agreed on a mutual position on the question of the Irish border.

It then dropped sharply when it became clear that this wasn’t the case, with Theresa May and Jean-Claude Juncker delivering a joint press conference to announce that, while “progress” had been made, some issues surrounding the Northern Ireland-Republic of Ireland border still need to be ironed out.

“Despite our best efforts and significant progress teams have made in recent days, it was not possible to make a complete agreement today,” May said.

That fall extended into Tuesday and has now continued into Wednesday as well.