Investors became significantly more apprehensive about the UK this past week. On 2 October at the Conservative Party’s annual conference, Prime Minister Theresa May announced her intention to trigger the UK's withdrawal from the EU by invoking Article 50 of the European Union Treaty no later than the end of March 2017.
This announcement was a reality check for investors, who had been reassured in recent weeks by the Bank of England's strong response and by brightening confidence surveys (including PMIindicators). Investors were particularly unsettled by Mrs May’s preference for a ‘hard Brexit’ – leaving the EU after only limited negotiations. One of the most damaging consequences of this approach would without a doubt be that British financial institutions would lose access to the EU’s financial markets.
The pound subsequently plummeted against most currencies, losing 4.1% against the US dollar between 30 September and 7 October (see left-hand chart) and 3.8% against the euro. This was accompanied by huge movements by the pound thought to be due to technical problems (possibly caused by automatic trades on electronic trading platforms).
The British equity index reacted, of course: the FTSE 100 rose by 2.1% in pound terms.
- Our expectation that the pound would fall following the Brexit vote proved accurate. Political uncertainty and structural imbalances in the UK economy – large budget and current account deficits – will continue to weigh on the pound in the coming months.
- We are maintaining our current forecast: $1.22/£ at the end of 2016 and $1.20/£ at the end of 2017. We still expect the pound to fall further if UK financial institutions lose their passporting rights and if clearing houses move to the Eurozone. In that case, the pound could lose some ground to the dollar, reaching $1.00/£, and even more to the euro, hitting £1.20/€.
- The pound’s loss in value should fuel inflationary pressures in the UK. It could hit 3.5% in 2017 according to our forecast. Still, the rise in the Gilt 10-year yield (1.00% at end-2016, 1.30% at end-2017) should be held in check if the BoE decides to extend its quantitative easing programme through 2017.