All records smashed in currency markets after the UK referendum - Nomura

Bilal Hafeez, FX Strategist at Nomura, notes that all sorts of records have been smashed in currency markets after the UK referendum, adding that we have yet to see the end of pound weakness, with a move to below 1.25-1.30 very likely in the days and weeks ahead.

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The pound against the dollar experienced its largest one-day decline ever, at around 8.5% last Friday. The previous largest decline was on the pound’s exit from the Exchange Rate Mechanism (ERM), when it fell 4%. Similarly, the daily range last Friday was close to 13%, which was double the range seen on the ERM exit.

Past large declines in the pound give mixed signals on whether the pound will continue to weaken. Looking at the previous top-ten daily declines since the beginning of the freefloat period in 1973, we find that the median GBP/USD move over the following week was +0.3%. One month after the sharp drop, it was still only +0.3%. Three months later, though, it was close to 4% lower.

The periods, which did see continuing declines, were characterised by a very overvalued pound at the time of the initial plunge. The time around ERM was a notable case, but so was the early 1980s, when tight monetary policy resulted in an overvalued pound, only for a recession to trigger a collapse in the pound. The other case of continued pound declines was after the global financial crisis in 2008.

Today, the pound is not heavily overvalued, at least not according to our favoured valuation metric of PPP (fair value is around 1.35-1.40). Meanwhile, we don’t think the Brexit means a financial crisis is in the offing – central banks are too ready to act for that to happen, we believe. Rather Brexit is a political crisis coupled with a negative economic shock.

The uncertainty generated from a lack of a functioning government in the UK, the lack of a roadmap of a new deal for the UK after its exit from the EU and the lack of clarity around the continuation of the British Union likely will weigh on investment into the UK. This is at a time the UK has its largest current account deficit in decades and has been receiving record capital inflows. A pause or sudden stop in these flows will necessarily force the pound to continue to weaken to allow the current account deficit to be reduced. We therefore don’t’ think we have seen the end of pound weakness, and a move to below 1.25-1.30 is very likely in the days and weeks ahead.