Hope for the pound, crossed out by Brexit

31 Jul 2018 17:49|Marcin Lipka

“On Thursday, the Bank of England can raise interest rates. However, it is possible that the decision, which usually evokes great emotions among investors, will go unnoticed this time. This is because everyone is gripped by the looming Brexit and the enormous uncertainty that it entails, which is much more damaging to the pound than raising interest rates could help,” writes Marcin Lipka, Conotoxia Senior Analyst.

An increase in interest rates affects the prices of stocks and bonds, the value of the local currency or the cost of financing businesses and households. Theoretically speaking, the emotions ahead of the Bank of England meeting on Thursday should be high. However, it is likely that they will sink quite quickly, due to the upcoming Brexit and the expected chaos involved in the process.

If the majority is right, there will be an increase

An increase in the interest rate by 0.25 percentage points to 0.75% is highly probable. The chance of upward movement is about 90%. Moreover, the vast majority of economists also believe that the monetary value will be raised for the British people. 47 analysts surveyed by the Bloomberg agency predict a tightening of monetary policy, while only 11 expect that monetary conditions will remain unchanged.

There have been signs suggesting an increase since the last meeting of the Bank of England (21 June). At the time, three out of nine BoE members (including Chief Economist Andy Haldane) voted in favour of the increase. The tone of the announcement and the minutes (a record of the discussion at the meeting) also made it necessary to prepare for higher interest rates in the nearest future.

In the last month, mixed data (lower than expected retail sales, industrial production and inflation, and better than consensus were the expectations of entrepreneurs and the employment data) were delivered to the market, but probably macroeconomic readings did not differ from the central bank's forecasts to postpone the increase for the following months.

As a result, it must be assumed that we will see the increase. Its absence could create more uncertainty than a real tightening of monetary policy. But can this help the pound?

Brexit more important for pounds than interest rates

Typically, an interest rate increase supports the local currency. However, in the case of the pound, the situation is much more uncertain. Firstly, because it is already practically fully valued. Secondly, as previously suggested by the central bank, it can happen in a year's time, which means that the news after the meeting will highlight the argument for an extended period without increases rather than further upward movement.

In addition to these two reasons, there is also a third, the most important one. Investors are paying much more attention to Brexit, which will physically take place in eight months.

Market participants are particularly worried about the fact that for more than two years London has not even drawn up a draft for future relations with Brussels. The idea (suggested three weeks ago) of maintaining duty-free trade between the EU and the UK and having a separate trade policy with third countries, which was suggested in the White Paper, is unacceptable for the EU due to the complex system of registration and customs clearance of goods that cross UK borders, destined for the EU (and vice versa).

The White Paper also presents a poor plan for British financial services, which may be acceptable to the EU, but is so negative for the City of London that its implementation would cause the sector to migrate to the European continent. The plan for the future border between Northern Ireland and the Republic of Ireland is also unclear, which, once again, shows the lack of power of the British administration to find a logical solution to the basic problems of leaving the Union.

Never-ending dispute over the divorce

Not only is the exit from the Union clearly overwhelming for the government in London, but it is also unclear whether new elections would solve the problems. For example, although the Labour party is in favour of having closer relations with the EU, it does not clearly address the repetition of the referendum. Some Labour members also prefer a hard Brexit, i.e. leaving the Union, if Brussels does not agree to London's conditions.

The divisions between the ruling Tories look similar. Some members of Theresa May's cabinet are in favour of a soft Brexit (close relations with the EU) and others in favour of a hard one. This generates a significant level of uncertainty and increases the probability of extreme scenarios.

In such an environment it is difficult for entrepreneurs to plan investments and more. It also has a negative impact on the economy. The Bank of England analysis from early July showed that GDP grew by 1 percentage point less than in the pre-referendum scenario in 2016. Earlier, the Bank of England had also estimated that an average household had already lost GBP 900 from Brexit, which has not even happened yet.

Taking all the elements into account, the condition of the pound can only improve for a moment after the interest rate increase. Currently, the risk of a disorderly Brexit is increasing, which could even mean that the pound would be priced at PLN 4.50. There is also hope. Perhaps there is method to all of this madness and the confusion will be used to completely reverse Brexit. This scenario is not at all absurd, considering what we have seen in the United Kingdom over the last three years. The pound would then rise well above the limit of PLN 5.

 


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