HSBC Brexometer points towards Hard Brexit

We haven’t heard much about Brexit so far… This is going to change. UK’s PM Theresa May is expected to give a speech about her strategy to manage UK’s exit from European union: it’s a two-option strategy: « Soft » or « Hard » Brexit, with consequences that few can yet imagine, since Brexit in itself will be a very lengthy process.

Strategists at HSBC have devised a barometer dubbed « Brexometer » to assess financial markets view of the process. No surprise there, they just looked at how the cable’s behaving since the vote of June 2016. Here’s their explanation of the underlying logic of this barometer, published in a note date Jan 10:

« Currencies are driven much more by political developments than in the past. This closer relationship between FX and politics means we can also use currency movements to inform us of the market’s view of political outcomes. In the UK, movements in GBP since the EU referendum in June tell us what type of Brexit the market is expecting. We use this relationship to create a “Brexometer” – a number between 0 and 100 telling us how hard a Brexit the market is expecting. »

Source: HSBC

Current reading of the barometer is at around 74, at the « border line of a hard Brexit », but as the following graph shows, it has been quite volatile. If you ignore the « flash crash » early October (which has just been explained), the barometer has been flirting with the hard Brexit line for the last 3 months.

Source: HSBC

The above image looks almost exactly as a reflection of the GBP/USD exchange rate over the last year (no surprise here):

Source: Bloomberg

What’s the lower bound if hard Brexit is to be a reality ? According to HSBC, the GBP/USD parity could go to 1.10 vs 1.2182, meaning the cable has potentially a further 10% downside risk.

If you now look at the long term value of the cable, using for instance the Peterson Institute latest estimates of equilibrium exchange rates, the GBP/USD exchange rate should be closer to 1.32. This estimate is surprising though, since the economic situation of the UK is expected to deteriorate (for instance, by 2021, IMF expects the adjusted current account to reach -2.9% of GDP, while euro area adjusted current account is seen at 3% of GDP by the same time).

And that’s also one of the point HSBC makes in its report:

« On the basis of the UK’s external deficit we argued GBP needs to adjust lower. However, as time marched on it became clear that there is now a co-dependent relationship between the currency and the political landscape. » (bold statement from the author of the report).

 

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