Surprising sterling resilience to Brexit unlikely to last - Capital Economics
UK Economics

Surprising sterling resilience to Brexit unlikely to last

UK Economics Update
Written by Ruth Gregory

Despite the news that the latest round of UK-EU Brexit negotiations ended in deadlock last Friday, sterling has remained remarkably stable. This suggests that while there may be some small upside for sterling if a slim trade deal is agreed by 31st December 2020, the risks are skewed heavily to the downside.

  • Despite the news that the latest round of UK-EU Brexit negotiations ended in deadlock last Friday, sterling has remained remarkably stable. This suggests that while there may be some small upside for sterling if a slim trade deal is agreed by 31st December 2020, the risks are skewed heavily to the downside.
  • The news that the Brexit talks remain deadlocked, and the UK draft legal text submitted last week is some way from what the EU has said it would accept, might have been expected to take a toll on sterling. But despite the chances of “no deal, no extension” by end-2020 implied by betting odds increasing from 28% on 17th August to 41%, the pound has risen to €1.12, above where it was before last week’s talks. (See Chart 1.)
  • There has also been little sign that investors are positioning themselves for the increased chance of a no deal. If anything, investors’ concerns about the UK leaving the EU without a deal have faded. Demand for options protecting against a fall in sterling has dipped to a five-month low. Investors are placing more bets on sterling rising rather than falling. (See Chart 2.) And volatility in £/€ is below that in $/€. (See Chart 3.)
  • Sterling’s limited reaction probably reflects the fact that the latest developments have not altered the view in the markets about the likelihood of a Brexit deal being reached by 31st December. Like us, investors may have concluded that if an agreement is reached, it won’t be until the eleventh hour – perhaps in November or at an EU summit on 10th-11th December. Alternatively, the muted reaction could be a sign of Brexit fatigue, with the markets putting much less weight on the Brexit news now than they used to given the myriad twists and turns so far. Either way, sterling’s inertia is unlikely to last if the clock continues to tick down to 31st December without a deal in place.
  • In our base case, we still think that sterling will end 2020 at $1.35 and €1.13, up from $1.32 and €1.12 now. This is based on the assumption that a slim trade in goods deal is agreed. (See here.) But since investors do not appear to be fully pricing in the chances of “no extension, no deal” on 31st December, this suggests there is more downside than upside risk for sterling. Indeed, we wouldn’t be surprised if, in the event of no deal, sterling plunged towards, or a bit below $1.15 and €1.00. (See Table 1.)

Chart 1: Probability of No Trade Deal & €/£

Chart 2: Sterling Futures Net Position & $/£ Rate

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics

Chart 3: 3-Month Implied Volatility (%)

Table 1: Brexit Outcomes & Probabilities

Sources: Refinitiv, Capital Economics

Source: Capital Economics


Ruth Gregory, Senior UK Economist, +44 7747 466 451, ruth.gregory@capitaleconomics.com