The Morning Call

One week after the ‘leave’ (Brexit) outcome of the UK referendum, financial markets have stabilised. Bank of England (BoE) Governor Mark Carney delivered a statement noting that the BoE will likely have to ease policy over the summer and continue weekly liquidity auctions until end-September. In August, the BoE will be the first official institution to produce forecasts following the ‘leave’ vote in the August Inflation Report. We recently lowered our growth forecasts to 1.2% for 2016 and 0.5% for 2017 from 1.9% and 1.5% respectively. Carney said that in the August meeting the BoE will also discuss the further range of instruments at its disposal; for example, a type of funding-for-lending programme aimed at keeping spreads between the Bank Rate and actual business and household lending rates as tight as possible.

On Tuesday, the BoE’s Financial Policy Committee (FPC) will meet as part of its regular bi-annual meetings. The BoE has already said that it is considering reversing the decision to tighten bank capital requirements. We think this move is appropriate as the banking sector is one of the hardest hit by Brexit-related uncertainty.

Although GBP-USD is down c.11% since the referendum results began to show a ‘leave’ outcome, we believe the GBP is under-pricing UK political risk. GBP crosses’ traditional relationship with interest rate differentials suggest that the GBP Trade Weighted Index is pricing in a political risk premium of only 7.1%, which is below the maximum risk premium priced in ahead of the referendum, when Brexit was a mere possibility.

Attention has shifted to politics, especially the Conservative party leadership process. We believe the limited GBP sell-off is due to some market expectations that Article 50 will not be triggered and the UK will not exit the EU. Four out of the five Tory leadership candidates have laid out their strategy for the UK and its future relationship with the EU; all have taken the view that the UK’s vote to leave the EU is binding. All have indicated that there will be no second referendum on EU membership or early general election. Options for the UK not to trigger Article 50 and begin the process of leaving the EU are becoming increasingly scarce.

We believe political developments ahead of the UK triggering Article 50, along with deteriorating economic data and financial market stress, will lead to GBP weakness through H2 and we forecast GBP-USD at 1.18 by end-2016 (see FX Alert, 28 June 2016, ‘Brexit fallout - Divorce requires change’).