GBP, ‘Brexit’ and the kindness of strangers

1. Since November, Sterling has weakened by around 8% on a trade-weighted basis (Exhibit 1). There is no shortage of explanations for the decline – over this period, Bank of England communication has become more dovish, the ECB surprised hawkishly relative to market expectations in its December meeting, the Fed hiked, markets have fallen on China concerns and, finally, ‘Brexit’ has moved into sharper focus. In today’s FX Views, ahead of February’s EU Council meeting – whose agenda includes Britain’s renegotiation with Europe – we ask what kind of impact a ‘Brexit’ would have on the GBP should it occur, and whether the GBP is already pricing some degree of ‘Brexit’ risk. We argue that, if the UK voted to leave the EU, the UK’s current account deficit would still be a source of vulnerability despite some recent improvement. An abrupt and total interruption to incoming capital flows in response to a ‘Brexit’ could see the GBP decline by as much as 15-20%. So far, the declines in Sterling are consistent with the declines in UK rates and the global risk backdrop, but some signs of a ‘Brexit’ risk premium are appearing. Nevertheless, our base case assumes the UK will remain in the EU, and that cyclical strength should eventually re-send EUR/GBP back below 0.70. We forecast EUR/GBP at 0.68 and GBP/USD at 1.40 in 12 months.

2. Our base case forecasts for Sterling do not envisage that the UK will leave the EU. However, given the market attention on the possibility of a ‘Brexit’, it is worth asking what the potential impact on the GBP would be should the UK vote to leave. As we argue below, one way to understand the potential impact is to assess the vulnerability of Sterling through the UK’s current account deficit. Last week, BoE Governor Mark Carney reiterated that the UK’s current account deficit meant that the UK was dependent on inflows of foreign capital – in effect that the UK economy relied on the “kindness of strangers”. That the UK has a current account deficit is, of course, nothing new, and we have previously argued that, although the deficit is a key risk to Sterling, the magnitude of the deficit in recent years overstates that risk. Indeed, the recent improvement in the current account numbers confirms our view that the current account deficit, driven particularly by a deterioration in the income balance, should continue to improve. Nevertheless, the latest reading of the current account deficit, at 3.7% of GDP, still points to a vulnerability should capital inflows slow (Exhibit 2). And a vote for the UK to exit from the EU is an event that would increase uncertainty, weigh on the UK outlook and raise concerns of foreign investors – potentially interrupting the flow of capital to the UK, sending the Pound much lower.

3. What sort of downside for Sterling could be expected should the UK vote to leave the EU and capital inflows slow? The number of moving parts in such a discussion precludes any definitive answer, but we can estimate the potential magnitude of a move. One way to do this is to assume that a ‘Brexit’ decision causes an interruption to capital flows into the UK that forces a sharp closure of the current account deficit, admittedly a strong assumption. To do this, we revisit our ‘FEER’ (fundamental equilibrium exchange rate) framework for the UK economy, first introduced here, which estimates the relationship between movements in the currency, domestic demand and the current account. Using this model, we can ask what degree of depreciation of the Pound would be required to close the deficit. When we impose a full closure of the current account via the exchange rate (rather than domestic demand) from the latest available level of 3.7% of GDP, our rough estimates would imply a drop in the trade-weighted GBP of 15-20%. If the move was uniform across currency pairs, this would take GBP/USD to around 1.15-1.20 and EUR/GBP to around 0.90-0.95. This could be smaller if there was a larger adjustment in UK domestic demand. But, in our framework, a decline of 2% in domestic demand would still see close to a 15% drop in the GBP to close the current account deficit.

4. Are these numbers plausible? A useful, albeit imperfect, comparison is the depreciation of the GBP during the global financial crisis between July 2008 and March 2009. During this time, the currency fell by around 20% on a trade-weighted basis and the current account moved from a 3.4% of GDP deficit – similar to today’s deficit – to basically zero. The circumstances of the crisis were admittedly extreme – and so a reasonable objection is that a full closure of the current account may not be necessary following a ‘Brexit’, requiring a smaller adjustment in Sterling. On the other hand, disorderly moves in a currency can become detached from economic fundamentals in the short term, and ‘overshoots’ are always a possibility. The other important consideration is the response of policy makers. The Bank of England would be loath to allow currency markets to perceive a ‘one-way bet’ in GBP and, as Andrew Benito argues (see here), an abrupt depreciation in Sterling may prevent a dovish monetary policy response (and may even lead to action to defend the currency).

5. So how much is Sterling already pricing ‘Brexit’ risk? Over the last few months, the rapid decline in the GBP has coincided with both dovish BoE communication and rising concerns around a ‘Brexit’. Since December, the Bank of England has struck a dovish tone – in particular, Governor Carney with commenting in January that “now is not yet the time” for rate hikes – which has pushed back market expectations considerably. Indeed, in early January we changed our own forecasts for the timing of the first rate hike by two quarters, and now expect the first rate hike in Q4 2016.
The market is currently pricing the first rise in Q1 2018, with significant probability of a cut by October this year (Exhibit 3). Although we ultimately expect this pricing to prove too dovish, the BoE’s continuing focus on downside risks to inflation constitutes a cautious message (something this Thursday’s meeting is likely to reiterate). Using our standard regression framework, which models currency movements based on interest rate differentials, with controls for risk appetite and oil prices, we can see that the move in GBP/$ is somewhat consistent with the movements in rates and risk sentiment. However, GBP/$ has weakened by more than rate differentials would imply – this ‘unexplained’ residual suggests some emergence of idiosyncratic risk, perhaps related to ‘Brexit’ fears (Exhibit 4). This is even more apparent in EUR/GBP, which is notably higher than would be implied by the move in rate differentials.

6. Ultimately, our forecasts are based on a view that the UK will remain in the EU and that, as a result, the underlying dynamics will remain solid in the UK economy.
We expect that the erosion of economic slack – particularly in the labour market – will eventually drive a tightening cycle faster than the market is currently discounting. Against a ECB with plenty of work to do to support inflation, this should see GBP re-visit recent lows in EUR/GBP over the next year. We continue to forecast EUR/GBP at 0.68 and GBP/USD at 1.40 in 12 months.

George Cole, Robin Brooks and Michael Cahill – Goldman Sachs International