Calm Before the Storm

If you are consuming the daily feast of UK political upheaval and Brexit chaos as the UK careers towards the 31 October cliff edge with little prospect of a deal, you might wonder, where’s the currency volatility? It should be significant, and probably with a downside bias. So what gives?

The political chaos was predictable. Indeed, ahead of the EU referendum, constitutional and trade experts warned that a ‘cake and eat it’ Brexit was simply undeliverable. The EU has a red line – maintaining the exclusive benefits of the ‘the four freedoms’ for their members – which the UK seeks to cross, leaving the club to seek partnerships elsewhere while keeping the benefits they like. The result is a protracted and difficult negotiation. But did you really need to be an expert to see that outcome?

Perhaps the simple explanation for sterling’s underwhelming reaction to the daily feast of chaos is the age-old market adage: if it is in the papers it’s already ‘in the price’.

Chart 1 shows sterling’s trade-weighted value over the past 20 years. As can be seen, sterling has depreciated by approx. 20% from pre-referendum highs and approx. 30% from pre global financial crisis (GFC) highs. The 20% fall after the referendum from already depressed levels has arguably priced in a lot of bad news, and the subsequent lack of volatility could simply be that what was priced in has been delivered.

Chart 1: Sterling Trade-Weighted Index

Another possible explanation for the lack of reaction in the pound is that nothing has happened yet and the market is ignorant of when something will. Article 50 deadlines that were supposedly set in stone have come and gone, while UK companies continue to enjoy all the benefits of the EU single market with no change.

If your glass is half full, you could say that the economic impact so far has been much less than predicted. Growth has been weaker, yes, but not dramatically so; unemployment has been steady; and the inflationary impact of sterling’s fall has come and gone. What were those doom-mongers on about? Alternatively, if you consider that so far nothing has changed in terms of market access for UK firms while the UK has benefitted from a big exchange rate depreciation and a lowering of interest rates and yet, despite this boost, growth has slowed down anyway, you might be thinking your glass looks a little empty.

Looking Beyond Brexit

We also must consider the pound’s behaviour in a wider context than the Brexit news flow alone. How are economies and exchange rates behaving more generally?

In the post GFC world, exchange rate volatility has, on average, been lower than before. There are many competing explanations for this, but in the context of EUR/GBP, the pinning of euro area and UK interest rates to near zero or below means that significant changes in relative interest rates are unlikely to be a driver of significant FX volatility – even if Brexit turns out to be as bad as the worst fears.

Again, this is a double-edged sword. It may be comforting that sterling isn’t collapsing because interest rates in the euro area are so low, or you may be asking where the buffer for the UK will come from if the hardest Brexit is delivered.

The Dampened G7 Growth Cycle

A dampened growth cycle seems to have prevailed in the post GFC world, at least in the G7. And again, this has corresponded to lower currency volatility. This dampening, along with the fairly muted growth/unemployment response to the referendum result, may have fostered excessive confidence that nothing much will change after Brexit whatever it looks like.

There are many explanations for the dampened cycles that have occurred in the G10, however, you don’t have to look far into the emerging markets to see that big growth shocks are still very possible. If there is an outcome where the UK can no longer participate efficiently in EU supply chains and UK access to EU service markets is eroded rapidly by regulators who no longer have an Anglo-Saxon perspective or veto to consider, then more extreme growth and volatility outcomes could lie ahead.

A Psychological Perspective

One non-economic explanation for the apparent calmness of markets comes from work carried out in the field of psychiatry regarding the human response to periods of extreme stress. In particular, how humans react in a war zone. At first, extremely high levels of adrenaline are released – during air raids, for instance. However, the body cannot maintain this extreme response over a prolonged period and a new state of apparent calmness prevails. What psychiatrists start to observe is fatigue, with slower reaction times, indecision, disconnection from one’s surroundings, and the inability to prioritize. You could use that set of adjectives to describe the post referendum world. Perhaps the sterling, then, is simply in a state of shock. These symptoms tend to be short-term and they correct when the environment normalises.

Too Uncertain to Price?

Markets don’t like uncertainty, primarily because of its ultimate impact upon economic activity. In the case of Brexit, all paths still seem to be possible – some very positive for the pound, some, like a ‘Hard Brexit’, very negative. You can plausibly argue for a multitude of outcomes: the UK will stay in the EU, leave the EU and join a customs union with the EU, leave the EU with a Theresa May style deal, or leave with no deal at all. And those outcomes could unfold anywhere between the end of October and some unspecifiable future date. How are markets supposed to price that?

Conclusion

The dramatic news keeps arriving and the pound remains an apparent haven of tranquillity. How can this be? Well, a lot is already priced in and perhaps too much comfort has been generated by what might turn out to be the calm before the storm. We don’t know when we will have clarity on the separation arrangements, let alone the future arrangements, but using the present calm as a reason to argue in favour of the most extreme Brexit may yet turn out to be a significant mistake. If a hard Brexit is delivered and European regulators take services in a non-friendly direction for the UK, then further sterling weakness and volatility is likely to lie ahead.

Paul is an FX and macro expert with 30 years of practical experience, having spent the last 20 years as Portfolio Manager. He was most recently Head of Currency at Insight Asset Management and previously Head of Currency at Union Bank of Switzerland Asset Management. Prior to that, Paul built and led a new macro fund at Polar Capital Partners and was Global Head of Currency at Deutsche Asset Management.