Some recovery potential for the pound

British pound

The rate of the British currency is like a seismograph of the Brexit negotiations.


(Photo: dpa)

Frankfurt Boris Johnson is currently facing many problems. The British Prime Minister must contain the rising number of corona infections in Great Britain. He also recently lost two of his key employees and is in quarantine after meeting an MP who tested positive for the coronavirus.

The time for the quarantine is extremely inconvenient. Because in the coming days or weeks it could be decided whether Great Britain and the EU agree on a common trade agreement or the talks fail. The decision is likely to have a significant impact on the development of the British pound.

Since the British voted for Brexit in 2016, the exchange rate of the British currency has been like a seismograph for the current state of negotiations. Most investors are currently assuming that both sides will come to an agreement.

“We are closer to the trade agreement than ever,” says Stephen Innes, market strategist at the broker Axi. The analyst at DZ Bank, Sonja Marten, on the other hand, expects that “a deal will not be announced before the end of the year”, if it comes about at all.

Also her colleague Esther Reichelt from the Commerzbank is rather skeptical whether a breakthrough is imminent. “Both sides have to show that they have negotiated hard,” she says. It is therefore quite possible that they will fully exhaust the deadline for negotiations.

Pound is quoted at around 0.89 pounds per euro

At the moment, however, everyone in the market would assume that both sides would agree. The signals in this direction have been intensifying since October. At that time, Great Britain’s Prime Minister Boris Johnson announced that he wanted to end negotiations with the EU – without an agreement if necessary. As a result, however, both sides had come together for further negotiations.

Reichelt therefore assumes that the pound’s reaction should not be too great in the event of an execution. “There might be a slight relief rally, but we don’t expect the pound to appreciate any longer,” she says.

Should the talks fail, however, a stronger devaluation of the pound can be expected. DZ Bank estimates that in this case the British currency is likely to lose around ten percent of its value across the board and the British economy will slide back into recession at the beginning of next year.

However, since this is not the main scenario, the institute only predicts a slight depreciation of the pound compared to the euro: it is currently trading at around 0.89 pounds per euro – in twelve months the DZ Bank is assuming an exchange rate of 0.92 pounds . Commerzbank, on the other hand, expects a somewhat firmer pound and forecasts an exchange rate of 0.86 pounds per euro for the end of 2021. Also the major Swiss bank UBS tends to be more optimistic about the pound.

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However, the forecasts are associated with high risks. Even if there is an agreement, British companies will probably no longer have as easy access to the European single market as they did in the past. How well prepared they are must be shown in practice. “Even after an agreement, there is great uncertainty as to whether the British economy will manage to adapt quickly to the new situation,” says Commerzbank foreign exchange analyst Esther Reichelt.

Key rate still positive in Great Britain

So far, investors have focused primarily on the question of what will happen to the negotiations by the end of the year. However, if the UK economy does not emerge from the crisis next year, the subject of negative interest rates could also come on the agenda even more. The key interest rate in Great Britain is currently still slightly positive at 0.1 percent.

The Bank of England is keeping the option of a cut below zero open. However, because of the possible negative side effects for the banking system, such a step is very controversial. Therefore, the UK central bank will probably only resort to the remedy if the economic outlook continues to darken, for example if a trade deal with the EU fails. Such a move would weigh on the pound according to foreign exchange expert Reichelt.

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Because when interest rates fall in Great Britain, it will be relatively more attractive for international investors to invest their capital in other currency areas. This would reduce the demand for the pound on the capital market and the exchange rate would tend to depreciate.

Especially if an agreement with the EU fails, a reverse step of an interest rate hike would not be entirely ruled out. That is when the pound comes under great pressure. The vulnerability of the British currency is also great because the country has had a high deficit in the current account for years, i.e. in trade in goods and services with foreign countries.

This means that the bottom line is that Great Britain spends more capital on goods and services from abroad than it earns from exporting there. To cover this deficit, it relies on capital inflows from abroad. Usually this is not a problem, but in certain situations it is.

Long-term Brexit consequences possible

“Due to the high current account deficit in Great Britain, the pound is susceptible to exaggerated reactions,” emphasizes Commerzbank foreign exchange expert Reichelt. Especially if there is no agreement with the EU, this could set in motion a downward dynamic. In this case, Reichelt may even consider a rate hike in Great Britain possible. The UK central bank could then be forced to take such a step to stop the downward momentum.

Even if there should soon be clarity about the future status of trade relations between Great Britain and the EU, the consequences of Brexit will continue to have an impact on the pound for a long time to come. In the short term, an agreement on a trade agreement with the EU should provide some boost – failure, on the other hand, would probably lead to heavy losses. The further development depends on how the UK economy handles the situation afterwards.

More: Pound investors have to be prepared for turbulence

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