How low could the pound go? - Capital Economics
UK Economics

How low could the pound go?

UK Economics Update
Written by Andrew Wishart

Our estimates suggest that if a no deal Brexit was fully priced into the market the pound would fall from $1.22 (€1.09) now to about $1.15 (€1.05) or a little lower.

  • Our estimates suggest that if a no deal Brexit was fully priced into the market the pound would fall from $1.22 (€1.09) now to about $1.15 (€1.05) or a little lower.
  • Over the past few days the pound has weakened to two-year lows of $1.22 and €1.09 in response to a rise in the perceived likelihood of a no deal Brexit. How far the pound could fall if there’s actually a no deal depends on what’s already priced in.
  • Betting markets imply a 38% chance of a no deal Brexit, up from 30% last week. The corresponding fall in the pound suggests every 10ppt increase in the chance of a no deal Brexit equates to the pound losing 3½ cents on the dollar. (See Chart 1.) Were a no deal to happen, this is consistent with the pound falling to parity against the dollar, breaking the all-time low of $1.05 reached in 1985. However, betting odds probably underestimate the likelihood of a no-deal Brexit as they only cover the chances of one this year.
  • Indeed, other ways of gauging what is priced in suggest the markets are assuming a much larger chance of a no deal, presumably including the possibility of a no deal happening after a delay to Brexit, perhaps to allow for a general election. Chart 2 compares market interest rate expectations with the consensus among forecasters if there is a no deal and if there’s not. (See Chart 2.) If we assume the markets and forecasters have similar views on the outlook for interest rates in each scenario, market rate expectations imply there’s an 80% chance of a no deal by the end of 2020.
  • That probably overestimates the perceived likelihood of a no deal. After all, forecasters have been more hawkish than the market for some time. We suspect the truth lies somewhere between these two estimates. That suggests a 40-60% chance of a no-deal Brexit may be priced into the exchange rate.
  • That implies if there were a no deal the pound might fall by as much as it has over the past four months again, to about $1.12. We are sticking with our existing no-deal forecast of $1.15, but acknowledge the risks lie to the downside. Meanwhile, now a significant probability of a no deal is priced in, and given heavy betting against the pound (see Chart 3), there’s scope for it to rally if a no deal is avoided. Our end-2020 forecast if Brexit is repeatedly delayed is $1.30 and $1.35 if a deal is struck. (See Chart 4.)

Chart 1: Probability of a No Deal Brexit & $/£

Chart 2: Bank of England Policy Rate (%)

Chart 3: $/£ & “Speculative” Positioning

Chart 4: Exchange Rates

Sources: Betfair, Bloomberg, Consensus Economics, Refinitiv, CE


Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com