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Pound Could Be 10 Percent Higher at Year-End as No-Deal Brexit Risks Overblown

A “no deal” Brexit remains highly unlikely according to experts at Goldman Sachs and ING, and as such the pound is grossly undervalued and could rise strongly from current levels.

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The pound has been through the wringer in recent weeks following a breakdown in Brexit talks between the UK’s Conservative and Labour parties, coupled with a backlash against Theresa May’s “last chance” offer to MPs — she offered a fourth vote on her impossible-to-pass withdrawal deal tied to a confirmatory second referendum.

Against the dollar, sterling lost value in 16 of the 19 trading days between May-6 and May-30, culminating in an exchange rate of only $1.258 — a 4-month low and 6 percent lower than valuations in March.

Nearly all of sterling’s recent decline has been driven by a perceived increase in the likelihood of a no-deal Brexit. Following the announcement of Theresa May’s resignation as British Prime Minister, political commentators throughout Europe insisted that no-deal was a very real possibility, based on an expectation that an ardent “Brexiteer” will win the keys to Number 10.

GBP to USD - 1 Week chart to 31 May
GBP/USD - 1 Week chart to 31 May

While it may be true that no-deal is more likely than ever before, the actual probability of such an outcome remains extremely low according to experts at Goldman Sachs and ING, and that bodes extremely well for the British pound.

Earlier this week, Goldman Sachs said it had revised its no-deal probability to 15 percent, from 10 percent — a 50 percent increase in the bank’s no-deal expectations, sure, but an increase that still makes a disorderly Brexit a long shot.

ING, too, discounts no-deal for the most part.

“We think the risk of the UK going over the cliff-edge in October is … around 20 percent,” the Dutch bank’s Developed Markets Economist James Smith wrote last week.

“A Eurosceptic PM doesn’t necessarily mean no-deal.” Even if one were pushed for, “lawmakers would do all they can to avert it.”

“The leader of the opposition, Jeremy Corbyn, could initiate a vote of no-confidence in the government … [and] it’s possible that some of the more moderate Conservative MPs could leave the party and get behind the no-confidence vote,” Smith speculates.

“With MPs so against no-deal … this scenario is only a remote possibility.”

Using these assertions, it’s possible to estimate fair value for the pound.

A number of banks throughout 2019 have predicted GBP/USD rates between $1.4 and $1.5 in the event of an orderly Brexit, whether that manifests as a permanent customs union or as a deal similar to the existing one. A rate of 1.5 has also been suggested should Article 50 be revoked via a second referendum, which cannot be entirely ruled out.

GBP to AUD - 1 Week chart to 31 May
GBP/AUD - 1 Week chart to 31 May

What about no-deal?

In HSBC’s GBP forecasts, it predicted $1.10 in the event of no-deal, with ING itself suggesting $1.15 earlier this year.

For argument’s sake, we’ll strike the middle ground for all determining factors in a fair value calculation: we’ll use a no-deal probability of 17.5 percent (midway between 15 and 20 percent), a no-deal exchange rate of $1.125 (midway between ING and HSBC estimates) and a with-a-deal rate of $1.45 (2019’s median estimate, including revocation).

A simple calculation of 0.175 * 1.125 added to 0.825 * 1.45 implies a fair value GBP/USD exchange rate 10 percent higher than current levels, at $1.393.

While it would be unrealistic to expect an imminent surge towards fair value — it is, after all, perceived risks that keep the pound down in the dumps — Britain’s currency could and should be worth a lot more than it is now once Brexit clarity emerges. Let’s give it until the end of the year.

 

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Please note that the opinions of our authors are their own and do not reflect the opinion of Best Exchange Rates and should not be taken as a reference to buy or sell any financial product.
 

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