Pound Rally Forecasts Pegged to Brexit Deal May Be Too Optimistic

(Bloomberg) -- Analysts expecting the pound to rally more than 5 percent on a market-friendly Brexit resolution may be too optimistic.

Some see the pound rising toward $1.40 by the end of June on anticipation that the U.K. will opt for a softer Brexit, or even cancel it. While Parliament taking greater control of the process has boosted the chance of a more favorable outcome, these calls may prove overconfident as current pricing seems to mainly factor in positive scenarios and overlooks potentially negative factors.

A decisive Brexit development could prompt a substantial market reaction, but the follow through after the initial knee-jerk move may be shallow unless a disorderly exit takes place. The latter would take the market into uncharted territory and sterling could enter free-fall mode. Under any other case, investors will eventually take a step back and examine the reasons why they should keep chasing the price action higher.

Despite a drop of more than 1 percent since Tuesday, the pound remains the best performer among Group-of-10 currencies this year. While this suggests that the market isn’t as pessimistic on sterling as it was during the fourth quarter last year, it remains structurally short, both in the cash and options markets, according to two traders in Europe, who asked not to be identified because they aren’t authorized to speak publicly.

The argument that positioning would result in a significant short squeeze in pound-dollar overlooks current market dynamics, the political repercussions that may follow in Britain, the fact that short-term investors may be willing to fade a rally as they have a more balanced exposure, and that positioning partly has more to do with the dollar’s prospects.

Bank of England officials have hinted that tightening over the course of the next three years may be warranted after the divorce finalizes, but global growth risks, contained domestic inflationary pressure, a shaky outlook for house prices and weak productivity growth are no reasons for a tighter monetary policy than currently priced in.

The removal of Brexit uncertainty might alleviate the factors suppressing hopes for an economic rebound during the second half of the year, but it will take months of strong data to weigh on spot prices, not to mention that U.K. politics could remain a hurdle as Theresa May could step down, and a general election can’t be excluded.

Short-term exposure is fairly balanced as signaled by front-end risk reversals and the rather narrow range seen this week. Key technical levels that may show whether the U.K. currency could stage an impressive rally are $1.3564, the 200-weekly moving average, and $1.3637, the 61.8% Fibonacci retracement of its losses since April 2018. Bears may avoid taking profits on shorts until a test of February lows at $1.2773-85.

• NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

What to Watch:

• Chinese Vice Premier Liu He leads a delegation of trade negotiators to Washington on Wednesday, April 3
• Reserve Bank of Australia holds its regular monetary policy meeting on April 2
• U.K. Parliament to vote on Monday on alternative Brexit options
• Economic releases include euro-area inflation, U.K. PMIs and U.S. non-farm payrolls; see data calendar

--With assistance from Anil Varma.

To contact the reporter on this story: Vassilis Karamanis in Athens at vkaramanis1@bloomberg.net

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Scott Hamilton, James Amott

©2019 Bloomberg L.P.