Political uncertainty ahead of Britain's European Union (EU) referendum is showing up in the form of nervous investors and a weakening sterling. Meanwhile, the Bank of England's monetary divergence from that of the US Federal Reserve adds to the downward pressure on the British currency.
London - Picture this: investors facing a Brexit shock begin to scale sharply down on investment and lending, raising questions about the sustainability of the UK's current and fiscal deficits, which in turn leads to a sterling crisis. This is the gloomy scenario that the Berenberg analytics team gave in the event of a 'Brexit' in their latest outlook published on Monday. They attribute a low to medium probability of this scenario becoming reality.
"Sterling weakness would reflect negative factors: weaker demand for UK assets and a fall in demand by UK consumers for foreign goods and services," Berenberg wrote. Meanwhile, inflation would be boosted in the short-term, and British exporters would enjoy stronger exports to overseas markets on the back of a cheaper pound.
But a short-term increase in inflationary pressures would not lead to a change in the Bank of England’s (BoE) projected path for interest rates as "weaker demand could put downward pressure on prices," Berenberg argues.
In one of their latest FX outlooks, Rabobank analysts argued that even if pro-EU forces gain more support among the public ahead of the June 23 plebiscite, "the presence of political uncertainty suggests that the next four months have the potential to bring significant downside risk for sterling in addition to plenty of volatility".
Capital Economics recently warned that sterling may continue to slump against the US dollar even if the UK votes to remain in the EU, with their end of 2016 forecast down at $1.30. If Britain does decide to leave the EU, sterling's abyss at this year's end is seen hovering as low as $1.20.
"This is largely because we think the contrast between the policies of the Bank of England and the Fed will be starker than anticipated by the average investor. A further fall in sterling would be justified by the UK’s large current account deficit and something her monetary policymakers might be keen to preserve," Capital Economics argued.
The Fed is unlikely to continue raising the base rate in March, and is expected to wait until the summer to sift through the global headwinds and their impact on the US economy and the dollar. Meanwhile, the first rate hike at the Old Lady of Threadneedle Street, after more than seven years of ultra-loose policy, is still flickering far in the distance, like a mirage. Economists expect the first hike at the BoE to happen between the last quarter of this year and the first three months of 2017. Traders are less upbeat, seeing the first round of tightening to come as late as early 2018.
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