Sterling rally has Brexit bears scratching their heads

A small army of FX analysts have lined up in recent weeks to proclaim that the worst for sterling might be over, despite a hiccup in recent days over renewed speculation around a possible exit by Scotland from the UK.

Some are going even further and claiming the hugely undervalued pound is a good bet in almost any scenario regarding the UK’s future relationship with Europe.

“Theresa May has made it clear that if the UK is unable to conduct a successful negotiation over its future relationship with Europe then she would be very happy to walk away,” says Hans Redeker, global head of FX strategy at Morgan Stanley.

“Both scenarios may be good for the pound because either the negotiation will be favourable or the UK could set itself up as a deregulated low-tax economy, the success of which would be contingent on strong capital imports, which would themselves be sterling positive.”

Sterling was trading at 1.1738 euros on Monday, slightly below the two-month high of 1.1862 seen late last week, but still some five cents higher than in mid-January. 

“We think the pound will continue to strengthen against the euro, mainly because of the extremely negative valuation that we have seen that is not really reflected by fundamentals,” says Clara Leonard, an FX strategist at BNP Paribas (BNPP). “One driver is the fact that there are still a lot of short positions out there that will need to be unwound.”

On BNPP’s FX market positioning indicator on Monday, sterling was at -19 on a scale of -50 to +50, and the bank predicts sterling will rise another 6% against the euro by the end of the year.

A driver of some analysts’ bullish outlook for the UK currency is mean reversion theory, which is based on the assumption that the price will return to its long-term moving average over a period of time. On that view, sterling should rise.

Another more rudimentary driver of the exchange rate versus the euro is politics, and particularly the upcoming elections in the Netherlands and France. The Dutch general election will be held on March 15, with the far-right and Eurosceptic Party for Freedom leading the polls, and the first round of the French presidential election will follow on April 23.

In France, austerity champion Francois Fillon faces corruption allegations, while two leftist candidates are pursuing aggressive tax-increase agendas to fund economic stimulus and higher pay.

Far-right candidate Marine Le Pen has made no secret of her wish to take France out of the EU, and her election would likely lead to a sharp sell-off in the euro. Still, most banks and polls say the chance of a Le Pen victory is low.

“Our base case is that while there is some political risk that is weighing on the euro right now, the chance of a victory for Le Pen is somewhat of a long shot and the most likely scenario is something less extreme,” says Lee Hardman, a currency analyst with Japan's MUFG in London. 

Currently leading the polls is ex-banker Emmanuel Macron, who is running as an independent.

Still, as the elections have approached, implied volatility on the euro has risen sharply, reaching as high as 60% in recent trade, compared with 50% at the beginning of February, as investors hedged a surprise result.

One volatility contract to have been hit particularly hard is the euro/yen option, which reflects increased hedging from Japanese investors, who have been significant buyers of French government debt and likely have been alarmed to have seen spreads against German benchmarks widen sharply in recent weeks.

Ten-year Bund-OAT spreads were at around 72 basis points in recent trade, compared with as low as 20bp late last summer.

“The Japanese investor owns 13% of the French OAT market, mostly accumulated in the past two years,” says Morgan Stanley’s Redeker. “This large asset position is now at risk, should volatility in the euro bond market increase, and the Japanese have been net sellers of foreign bonds since the middle of January.”

If Japanese investors do make large disposals of French government bond positions, it will have a knock-on impact on the euro, adds Redeker.

Still, while the EU is facing some short-term challenges, they are relatively small in scale and less certain than those facing the UK, where the economy faces the unknown impact of casting away from its main trading partner. For some in the FX market, that is a more powerful dynamic than anything on the other side of the English Channel.

“With the Dutch and French elections coming up, sterling risk has been side-lined because it’s more of a medium-term story,” says Viraj Patel, an FX strategist at ING. “However, once the elections are out of the way, the risks for sterling may come to the front of people’s minds again.”

The UK economy is also starting to show signs of losing steam, after better-than-expected performance following the vote to leave the EU in June.

The dominant services sector grew in January, but at a slower pace than in December, while inflation hit 1.8%, the fastest pace since June 2014. Retail sales fell for the second consecutive month in January, suggesting that consumers are beginning to feel the squeeze.

“As sterling risk starts to pick up again, we would not be surprised to see it decline from here, moving from 85 pence per euro to somewhere close to 88, and from there back to its post-Brexit lows,” says Patel.