Pound Rally Seen Capped To 2018 Level On A Brexit Trade Deal

Currency strategists are delivering a reality check on how far the pound rally can go if the U.K. and European Union finally clinch an historic trade deal.

The general consensus is that much of the optimism is already priced in, with the currency up more than 9% since the end of June while the relative cost of hedging pound weakness over the next year at its lowest since March. The cost of insuring against swings in sterling over the next month fell to its lowest since September on Thursday.

Investors see limitations of any incoming accord and are looking ahead to the prospect of further coronavirus restrictions and the U.K.’s bleak economic outlook. The pound traded 0.6% higher at around $1.3580 at 1:15 p.m. in London.

“The announcement of a Brexit trade agreement should be temporarily bullish for sterling but we think that most of the good news is in the price and suggest taking profit around $1.36,” said Sheena Shah, currency strategist at Morgan Stanley. “The many uncertainties for the pound — local and global — lead us to expect it to be an underperformer for most of 2021.”

Any deal would conclude more than four years of fractious negotiations since the U.K.’s referendum on EU membership, setting up a new era of trade relations between Britain and the bloc. Uncertainty over the future and the expected economic damage from Brexit has held the pound captive below its pre-referendum range.

Yet the pact will only go so far. “New customs arrangements will introduce friction and additional cost for business,” said Jeremy Stretch, the head of Group-of-10 currency research at Canadian Imperial Bank of Commerce in London, who says most of the good news is already reflected in the pound. “The service sector, including financial services, has essentially been ignored by the U.K. government and hence is outside the deal.”

The pound will probably advance to $1.37 if the U.K. and European Union finalize a trade deal on Christmas Eve, according to Credit Agricole SA. While that’s the highest level since May 2018, it’s under a 1% gain from Thursday’s peak of $1.3619. CIBC says sterling could touch $1.3715, although it recommends selling the rally.

“The upside is pretty marginal now,” said Adam Cole, RBC Europe Ltd.‘s head of currency strategy, who says the pound will be overshooting if it exceeds $1.36. “Taking the bookies’ quotes as a proxy, the probability of a deal rose from 50% at the weekend to 90% yesterday, so I think the repricing is largely done.”

Low Liquidity

The caveat is that with liquidity diminishing during the Christmas period, sterling’s reaction to a decision over trade may be more volatile. Despite the holiday lull, demand for the pound from institutional investors was seen during the Asia session, according to a Europe-based trader who asked not to be identified because he is not authorized to speak publicly.

Manuel Oliveri, a foreign-exchange strategist at Credit Agricole, said participation may be low because many clients have already closed their books for the year. It’s one reason why an accord could send the pound soaring as much as 3%, before ending the day up 2%, Bob Stoutjesdijk, a Rotterdam-based fund manager at Robeco Institutional Asset Management, said on Wednesday.

– Bloomberg