Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 67% of retail investor accounts lose money when spread betting and/or trading CFDs with this provider. You should consider whether you understand how spread bets, CFDs, OTC options or any of our other products work and whether you can afford to take the high risk of losing your money.

Brexit risk keeps sterling weak

After the shocker of 2016 which saw the pound have its worst year since 2008, falling 16% against the US dollar and 11.5% against the euro, the pound was able to find a semblance of stability in 2017. As uncertainty over the appointment of a new Fed Chairman kept markets guessing about the outlook for US interest rates, UK Prime Minister Theresa May managed to get the framework of a withdrawal deal tied up with the EU just before Christmas.

The agreement last December in terms of the sequencing of the withdrawal agreement and trade talks with the EU, helped underpin a positive move for sterling as we moved into 2018. The UK economy, which had weakened due to the higher inflation brought on by the Bank of England’s sledgehammer stimulus in August 2016, is starting to show some signs that the worst of the inflation shock might be in the rear-view mirror.

This calmer environment boosted expectations that interest rates might rise again in May, following on from the November rise. Sterling’s increase over $1.40 in the first quarter of last year appeared to reflect that. A rather brutal cold snap, along with the collapse of the UK’s second biggest construction company Carillion did send shock waves through the UK economy, however, despite this there was increasing evidence that any economic weakness was likely to be temporary.

It transpired that not all of the Bank of England’s MPC were convinced. Having spent most of the last few months suggesting that a rate move in May was more or less a done deal, Bank of England governor Mark Carney surprised the markets three weeks prior to the May meeting by stating that markets should not assume that a rate hike was definite.

This sudden change in tone hit the markets like a well-aimed sidewinder missile, sending the pound sharply lower at a time when inflation was starting to fall quite nicely and wages were beginning to rise. The most recent guidance from UK policymakers, as well as the two votes to increase rates at the previous meeting, had raised expectations that a rate rise in May wouldn’t be expected to be significantly material in the short term.

In this context, yesterday’s comments were a surprise as the governor – in another triumph for the banks forward guidance – suggested that as a result of March’s weak retail sales numbers the timing of a rise might need to be pushed back. Putting to one side that in March the country ground to a halt due to the ‘Beast from the East’, this shouldn’t really have been too surprising or a significant cause for concern.

Nonetheless, in yet another triumph for the Bank’s forward guidance, the May inflation report came and went without a rate rise, and so began a summer where the UK economy grew strongly for two successive quarters. This was helped by a Royal Wedding, a World Cup where England beat expectations, and the summer weather.

Rates did eventually rise in August, but by then the damage had been done, with the pound dropping sharply from 1.4350 in April to lows of 1.2660 in August. The Fed had already raised rates twice, making it three rate rises this year, so part of that was down to Fed tightening. But once again, mixed messages from the Bank of England contributed to sterling weakness, as well as knocking central bank credibility on policy messaging for the umpteenth time. The Bank of England could learn lessons from the US Federal Reserve on how to communicate on policy effectively, as their current policy is utterly shambolic and disjointed.

In the Bank’s defence, the political situation continues to remain fraught which does make effective policy communication challenging. Nonetheless, the Bank has found itself drawn unnecessarily into the political fray, causing some to question its impartiality, with some previous MPC members being critical of its role as the current Brexit end game plays out.

We continue to hear calls of possible moves towards parity against both the US dollar and the euro, and once again it remains important to remember not to think in one dimensional terms when it comes to currencies. This continues to remain true given that currencies don’t operate in a vacuum and political risk is not a zero sum game.

The recovery in some parts of Europe has stalled and gone into reverse: Germany’s Angela Merkel could be gone by the end of the year, while the new populist Italian government appears to be keen to take on Brussels with respect to its budget, and France’s President Macron is fighting fires at home with riots in Paris.

Against this backdrop the outlook for sterling remains fraught, however barring a ‘no deal’ scenario which at the time of writing looks a 50/50 bet, the risky side of the trade remains for a move towards $1.40 during 2019.

It is also interesting to note that despite the fractious politics in Westminster and the shameful partisanship of our politicians the pound is only slightly lower against the euro, while a softer tone from the Fed when it comes to further rate rises could support the pound in 2019.

Source: CMC Markets

A positive outcome or development in Brexit talks is also likely to see interest rate rise expectations increase in the coming months, especially with wages rising at a rate of 3.2%. This in turn could see a rate rise in May, snowfall notwithstanding.

Even allowing for that the currency situation still remains unclear. The lows of $1.2000 in 2017 remain a key support level if we do break to the downside, with the key risks being a no deal Brexit, as well as a government collapse that augurs in the prospect of a Labour government.

We could get a situation where the deal goes through Parliament, but the government then finds it difficult to continue as a result of the DUP withdrawing their confidence and supply deal.

Given some of the rhetoric from senior Labour leaders, expectations of higher taxes, higher public spending and capital controls, we could see a rush for the exits in the event an election brings with it the prospect of Prime Minister Corbyn.

For now there doesn’t seem much prospect of that if gilt markets are to be believed, however a sharp slide in gilts and rise in yields could signal a change of tone and tide if the parliamentary maths starts to tilt towards a general election.

As regards to where the pound could go next its really all up for grabs with respect to contingency planning and the slow approach of the 29th March deadline, when we leave the EU, which means we could well head towards $1.15 on the downside, or $1.45 on the top side. With respect to where we go to next throwing a dart at the dartboard would probably afford one a greater degree of success.

Ultimately it all depends on the ability of our politicians to coalesce around a common position and see it through. For now that still looks a tall order, and on the basis of recent behaviour I wouldn’t trust many of them to run a bath, let alone arrive at a position to avert a political as well as economic crisis.

Background image

Find your flow: four principles for trading in the zone

Learn about the four trading principles of preparation, psychology, strategy, and intuition, and gain key trading insights from some of the world's top investors.

Get this free report
Mobile trading app


Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although we are not specifically prevented from dealing before providing this material, we do not seek to take advantage of the material prior to its dissemination.