After what feels like a dearth of volatility in the FX markets in recent weeks, sterling came under heavy pressure last week, closing down 2.2% versus the dollar and 1.6% against the euro. Economic data was sparse with only the latest UK unemployment figures to speak of which showed unemployment falling to its lowest level since October 1974. Meanwhile, average earnings was slightly lower than expected, but nevertheless, a reading of 3.2% suggests that tighter monetary policy could still be justified.

So, in the absence of any disappointing economic data, is seems safe to conclude that sterling’s recent demise was primarily the result of renewed political uncertainty in the UK. With the 1922 committee putting pressure on Theresa May to stand down, the question we are all asking is what happens next?

Attention this week turns to the European elections. The Brexit party are heavy favourites to win most seats unless the turnout is dramatically higher than normal (the UK only had a 35% turnout in 2014). We can’t really draw any firm conclusions from this beyond the fact that there are a number of Brexiteers very upset by the way the Conservative government has handled negotiations to date (and we all knew that anyway). Clearly the elections will send a telling message and have significant ramifications regarding the future of the EU, but that is a topic for another week.

The key event for sterling will come either next week or the week after when Theresa May takes her deal back to MPs for a fourth time with an improved package of measures. If it is rejected again (which appears likely given that Labour have already said they will vote against it) the PM will set a date for her departure.

The next step is a Tory leadership contest with a new leader likely to be in place before the Conservative party conference at the end of September. The bookmakers have Boris Johnson as favourite at 7/4, followed by Dominic Raab at 5/1 and both Jeremy Hunt and Michael Gove at 8/1. With the two front runners both Brexiteers, sterling has come under pressure on concerns that a hard Brexit becomes significantly more likely.

Our assumption here is that regardless of who the new leader is, the EU won’t grant the UK another extension beyond 31st October. Even if the EU were willing to reopen negotiations, there wouldn’t be time to renegotiate Theresa May’s deal and hence whoever is in charge would be left with a choice of a so called “hard Brexit” or ignoring the referendum and revoking Article 50. Clearly the latter would be positive for sterling, but the increased likelihood of the former is what has dragged the pound lower over the past couple of sessions.

In a note put out over the weekend, Goldman Sachs believe that regardless of whether the PM is replaced or the government falls, they continue to believe that an orderly exit is more likely than a reversal of Brexit. As such they place a 50% probability on a close variant of the current deal, 40% on ‘no Brexit’ and just 10% on a No Deal Brexit. Interestingly, they also expect a resolution in Q2 although note that their conviction is low.

Regular readers won’t be surprised to hear that we are significantly more pessimistic on the prospect of a deal being done well in advance of the 31st October deadline. We also see the probability of a hard Brexit being higher (circa 20-25%) and the probability of Article 50 being revoked lower (circa 25 – 30%). Ultimately our base case remains that a variation of Theresa May’s deal does get passed by MPs and hence we maintain our bullish forecast for the end of the year (assuming a circa 75 – 80% probability of a sterling positive outcome). However, like GS, this is now with less conviction and from a risk management point of view, we remain cautious about the risks of a hard Brexit or even a General Election.

Author: Marc Cogliatti