Brexit and the pound

Economics is the study of how people make choices under varying degrees of certainty. But it is the lack of certainty which concerns us at present as global geopolitical considerations impact on investors’ assessment of asset valuations. Here in the UK, the issue of Brexit further adds to the mix. We hear a lot about how this raises the risks to UK financial assets. However, we have to make a distinction between risk and uncertainty. As the economist Frank Knight put it almost a century ago in one of the earliest and most influential works on investment risk-taking, “there is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known.”

The valuation of risk underpins the insurance industry where actuaries have some idea of the possible range of outcomes. But there are some risks which we cannot hedge because we have no idea of the possible range of outcomes. Brexit falls into this category. Although there has been much concern about the fall in the pound in recent weeks, as anyone who has recently been on holiday abroad can testify, in truth it has traded in a relatively narrow range over the past three years after the initial post-referendum decline. The Bank of England’s trade weighted index, which is a broad measure of sterling’s value against a basket of currencies, has traded in the range 73 to 80 compared to a wider range of 79 to 94 in the three years prior to the referendum. Admittedly, it has traded at multi-year lows against both the EUR and USD of late but given the magnitude of the risks involved, it still surprises me that the pound has not traded even lower. Ten-year gilt yields have traded at all-time lows in recent weeks, in line with global trends, suggesting that the bond market has no real concerns about the UK government’s creditworthiness.

If we were to infer what was happening in the UK purely from watching market moves, we would not conclude that it was going through the most dramatic political crisis of modern times. One explanation for this apparently paradoxical reaction is that the markets cannot price what form Brexit is likely to take, let alone what happens in the event there is no deal, and are holding fire as a result. In other words, markets are trading an uncertain environment rather than a risky one. But we can gain some idea of currency market concerns by looking at trends in implied FX volatility, which is a measure of how much the market expects the pound to move. Three month implied GBP/USD vol has recently traded above 14% (chart above) – ahead of the 2016 referendum it was at 16% (and reached 18% in the wake of the referendum outcome). Aside from the period following the Lehman’s crash in 2008, when global assets were priced for the worst, we are close to the highest recorded levels of idiosyncratic sterling FX volatility.

Of course, the one thing that volatility measures cannot tell us is in which direction the currency is likely to move. But it is accepted that in the event of a no-deal Brexit, sterling will depreciate sharply. Since it is impossible to give any accurate assessment of how big the move is likely to be, we are reduced to taking the volatility measures as a guideline and applying a significant degree of judgement (or guesswork, if you prefer). Forecasting exchange rates is difficult enough at the best of times and these are not the best of times, so the indicative levels shown here should be treated as no more than that.

In the case of no-deal, my guess is that the GBP/USD rate will stabilise around 1.15 (a decline of around 5% from current levels) although it could initially go sharply lower to somewhere around 1.10 before recovering, if the experience of June 2016 is anything to go by. As has become evident in recent days, there is plenty of scope for upside in the event that a no-deal Brexit can be taken off the table. In the extreme case where the UK revokes the Article 50 notification the pound can be expected to rally strongly. Indeed, a simple model based on expected interest rate differentials suggests that fair value for the GBP/USD rate is around 1.50. The chart above shows that since 2016, the exchange trade has traded outside the model’s one standard error bounds which we can attribute as the risk premium baked into the currency since the referendum. Using this model as a benchmark, I reckon that this risk premium results in sterling being approximately 20% undervalued versus the dollar. 

To the extent that the currency acts as a barometer of the market’s assessment of a country’s economic health, the recent slide in sterling reflects the downbeat assessment of the UK’s prospects. But whatever happens in future, it is unlikely that current market levels reflect a stable equilibrium. Either the situation with regard to a no-deal Brexit gets worse, in which case the pound might be expected to fall further, or it improves in which case sterling’s fortunes will also recover. The events of the past few days, in which the prospect of a no-deal Brexit has at least been temporarily been put on the back-burner, suggests that there is some room for optimism. But a more sustainable recovery is unlikely until a permanent solution to the problem is found.