July 10, 2019 / 6:18 PM / 12 days ago

Hot summer ahead for sterling as UK economy, politics go sour

LONDON (Reuters) - Even after losing almost 20% of its value since the 2016 Brexit referendum, Britain’s pound continues to be dogged by economic, politic and diplomatic pressures, meaning investors now fear it could be in for another chaotic lurch lower over the summer.

FILE PHOTO: Pound Sterling notes and change are seen inside a cash resgister in a coffee shop in Manchester, Britain, Septem,ber 21, 2018. REUTERS/Phil Noble

With sterling still acting as the clearest expression of financial markets’ take on Brexit risks, another currency storm is brewing a little over three months before the third Brexit deadline of 2019.

The favorite to be next prime minister, Boris Johnson, sees that Oct. 31 date as set in stone, regardless of whether or not a deal is achieved with the European Union.

Economic soundings too have turned ugly again as factories, builders and retailers freeze and Bank of England chief Mark Carney - tipped by some as the next International Monetary Fund head - appears to have backed down on his relatively hawkish stance on further interest rate rises to protect the pound.

To top it all, Britain’s diplomatic relations with the world’s two biggest economies have deteriorated sharply just as it prepares to cut ties with the EU, its biggest trading partner.

A row with China over recent Hong Kong protests was compounded this week by an unprecedented war of words with Washington over leaked emails showing the U.K. ambassador highly critical of President Donald Trump’s administration.

The combination knocked sterling to its weakest in more than two years against the dollar, if a January "flash crash" incident is discounted GBP=D3. It is also at the weakest this year against a trade-weighted basket of world currencies.

(Graphic - Trade-weighted sterling: tmsnrt.rs/2G5B8Tr)

Against the euro, performance is even more dismal - it is set for a record tenth consecutive weekly fall against the single currency, briefly breaching the psychologically key 90 pence level for the first time since January EURGBP=D3.

(Graphic - Pound set for record losing streak vs euro: tmsnrt.rs/2YU4Xxq)

All the uncertainty over when and how Britain will exit the EU is now taking a heavy toll on the economy which had stayed relatively robust until the first 2019 quarter.

“Previously the narrative around sterling was that steady UK fundamentals would offset the messy politics, but that has now changed after recent data,” said Neil Mellor, senior FX strategist at BNY Mellon.

Data last week suggested the British economy may be on track for a possible contraction in the June quarter, manufacturers had their worst month in more than six years, while retail sales suffered a record annual fall for June

The result is that a Citigroup index of economic activity .CESIGBP in Britain has dropped to its lowest levels in eight years while similar gauges in Europe .CESIEUR have stabilized.

(Graphic - Citi Econ Index Europe vs UK: tmsnrt.rs/2G3HjHK)

The weak data has also chipped away at one of the last supports for the pound: the possibility of a Bank of England interest rate hike. The last of those hopes evaporated on July 2 as BOE governor Carney signaled he could be about to join other central bank peers in cutting rates.

Since that day, sterling has lost 1.6% and money markets now fully expect a quarter-point rate cut by February 2020.

But Kamal Sharma, a London-based director of G10 FX strategy at Bank of America Merrill Lynch, says a cut may come as soon as this November, given sterling will also face headwinds from the worsening global economic picture.

“Historically, the pound has been closely correlated to global growth and particularly to the euro zone growth outlook. Both of them have struggled,” Sharma said.

A large balance of payments deficit makes it particularly vulnerable compared to most other developed countries. The deficit was 5.6% of annual economic output in the first quarter, or around 30 billion pounds ($37.51 billion)

THIN AIR

The next big level for the pound versus the greenback is the January 2017 low of $1.20 after which the Brexit referendum low of $1.1491, hit in October 2016, beckons.

Its fresh declines mirror a renewed short-selling spree that has seen net short bets against the pound climb for more than two months, even if still some 40% below the record highs of April 2017.

(Graphic - FX market positions: tmsnrt.rs/2FPLRRN)

One reason traders give for why speculation in the futures market is not yet as extreme as two years ago is that investors are increasingly using options to bet against the pound or hedge against another steep drop.

On the face of it, implied sterling volatility derived from the options market appears to be low, but that merely reflects an ultra-low volatility environment for world currency markets at large and traders note sterling volatility is sharply higher than on other major developed currencies.

One-year implied pound volatility displays a premium of around 1.6 vol to the average vol of other G10 currencies, according to Adam Cole, chief currency strategist at RBC Capital Markets. Historically, sterling vol has traded at an average 1.5-2.0 vol discount, the following chart from RBC shows.

(Graphic - Pound volatility vs G10 FX volatility: tmsnrt.rs/2YOLbUc)

Moreover, six-month and three-month implied vols have risen in recent days, which Cole said was down to markets “taking the October Brexit deadline much more seriously than the (original) March deadline.”

(Graphic - October jitters: tmsnrt.rs/2YG2ruN)

Finally, whoever wins the leadership contest will face testy negotiations with the EU, which has already refused to reopen the Brexit deal agreed by outgoing prime minister Theresa May.

“Theresa May has done this unsuccessfully for several months now, and I am not sure whether the next prime minister can change that whether he is called Boris Johnson or Jeremy Hunt,” said Esther Reichelt, FX Strategist at Commerzbank in Frankfurt.

Reporting by Saikat Chatterjee; Additional reporting by Sujata Rao; Editing by Mike Dolan and Andrew Cawthorne

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