By Geoffrey Smith and Peter Nurse
Investing.com -- Turmoil involving Britain’s negotiations with the European Union over their trading relationship has hit sterling hard this week.
Prime Minister Boris Johnson now threatens to break the divorce agreement with the EU, prompting threats of legal action. The odds of a no-deal Brexit are increasing, along with the likelihood of an ugly outcome. The pound has fallen against the euro, plunging again on Friday to 1.08.
Investing.com's Geoffrey Smith argues the bull case for sterling, while Peter Nurse counters with reasons why it will continue to fall. This is Point/Counterpoint.
The Bull Case
It’s not often that you get to make an argument like this, but the bull case for sterling rests largely on the sheer spinelessness and brazen opportunism of the British government.
To sell sterling at these levels, you have to believe that the U.K. government is as stupid as it has pretended to be this week. You have to believe that it will go through with its threat to end the post-Brexit transition period without any deal at all to ensure smooth trade with the EU after Dec. 31 , and that it's willing to risk the anger of the U.S. by wrecking the Northern Ireland peace process in the bargain.
You have to believe that Johnson and his team seriously think they can win another election after pursuing a course of action that – for all the various arguments over sovereignty – can only result in more acute short-term pain for the British economy, and probably a higher level of chronic pain thereafter. You also have to believe that the EU, in the depths of its worst economic contraction ever, will willfully make things worse for the sake of an abstract faith in its Single Market.
The market has not believed that for most of the last four years, and its skepticism has been well founded on a succession of messy compromises that has delayed the hard choices between smooth trade and sovereignty. More of those compromises lie ahead, despite all the negotiating bluster to the contrary this week.
Certainly, the Withdrawal Agreement that was supposed to be the basis of a comprehensive post-Brexit deal appears dead. But ending the transition period without a comprehensive deal, regulating all the things that EU membership used to regulate from fisheries to international arrest warrants, is not the same as leaving without any mitigating arrangements at all.
It is already clear that the Bank of England and European Central Bank get on well enough – and are mature enough – to ensure that financial flows, underpinned by enforceable contracts, will carry on in January whatever happens. It is not hard to imagine a patchwork of sector-specific agreements being stitched together out of various short-term fixes to cover essentials such as perishable food and medicines. With time, such stopgap fixes can be smoothed out into more coherent and durable structures.
Barring hyperinflation – which is not a risk for the foreseeable future - currencies don’t go to zero. Over 20 years, EUR/GBP has never been able to sustain a level beyond 0.9250 for any length of time. Barring a failure of statecraft without parallel since the 1930s, the odds are on the pound’s side at these levels.
The Bear case
It’s true the recent turmoil surrounding Britain’s negotiations with the European Union over their trading relationship has hit sterling hard this week, but this doesn’t mean more losses aren’t possible, or indeed likely.
After all, while the pound has reversed some of its gains against the dollar after setting a high for the year at the start of this month, it remains higher than its 2019 average and well above the March low.
The move by the U.K. government to table a bill that would breach the existing withdrawal agreement, a move London openly says would contravene international law, has seen trust between the two sides largely disappear.
Indeed, investment bank Morgan Stanley increased the likelihood of Britain and the European Union ending up trading on World Trade Organisation terms to 40% from 25%.
"The risks are skewed to a harder outcome... bumping up the probability of our bear case of a WTO-style outcome to 40%. We still expect a delay in implementing the deal," the bank’s analysts said, in a note.
Even then, 40% isn’t 100%. Which means unless one of the sides is prepared to eat an awful lot of humble pie, sterling has room to move a lot lower.
Aside from the turmoil with the Brexit negotiations, worries surrounding the Covid-19 virus are on the rise.
A new study by Imperial College suggested the spread of the coronavirus is speeding up across all parts of England, with the number of cases doubling about every week.
That suggests Wednesday’s new restrictions on bars and restaurants will just be the start of a new series of lockdowns.
Britain has suffered the highest number of deaths from Covid-19 in Europe, and lockdown measures imposed meant the economy contracted a record 20.4% in the second quarter, by far the weakest quarter of the major industrialized countries in Europe.
Output did expand by 6.6% in July. But the furlough program, under which the government has paid as much as 80% of the wages of some 9.6 million workers, is due to be wound down altogether at the end of next month. More redundancies and thus a further hit to output are likely.
“We're likely to see the pace of expansion slow in August/September and stall as we head into the winter as the 'mechanical rebound' ends and unemployment rises,” said analyst James Smith at ING, in a note Friday.
This puts next week’s Bank of England meeting firmly in focus.
BOE Governor Andrew Bailey said last month the central bank has plenty of room to add more monetary stimulus, and it’s beginning to look like he may need to use this, a sterling negative.
“We think the overall size of the U.K. economy is unlikely to return to pre-virus levels until late 2022, or perhaps later. This in turn will increase the pressure on the Bank of England to increase their stimulus package at the November meeting,” Smith added.