Pound rally forecasts pegged to Brexit deal may be too optimistic

London: Analysts expecting the pound to rally more than 5 per cent on a market-friendly Brexit resolution may be too optimistic.

Some see the pound rising toward $1.40 by the end of June on anticipation that the UK will opt for a softer Brexit, or even cancel it. While Parliament taking greater control of the process has boosted the chance of a more favourable outcome, these calls may prove overconfident as current pricing seems to mainly factor in positive scenarios and overlooks potentially negative factors.

A decisive Brexit development could prompt a substantial market reaction, but the follow through after the initial knee-jerk move may be shallow unless a disorderly exit takes place. The latter would take the market into uncharted territory and sterling could enter free-fall mode. Under any other case, investors will eventually take a step back and examine the reasons why they should keep chasing the price action higher.

Despite a drop of more than 1 per cent since Tuesday, the pound remains the best performer among Group-of-10 currencies this year. While this suggests that the market isn’t as pessimistic on sterling as it was during the fourth quarter last year, it remains structurally short, both in the cash and options markets, according to two traders in Europe, who asked not to be identified because they aren’t authorised to speak publicly.

The argument that positioning would result in a significant short squeeze in pound-dollar overlooks current market dynamics, the political repercussions that may follow in Britain, the fact that short-term investors may be willing to fade a rally as they have a more balanced exposure, and that positioning partly has more to do with the dollar’s prospects.

Bank of England officials have hinted that tightening over the course of the next three years may be warranted after the divorce finalises, but global growth risks, contained domestic inflationary pressure, a shaky outlook for house prices and weak productivity growth are no reasons for a tighter monetary policy than currently priced in.

The removal of Brexit uncertainty might alleviate the factors suppressing hopes for an economic rebound during the second half of the year, but it will take months of strong data to weigh on spot prices, not to mention that UK politics could remain a hurdle as Theresa May could step down, and a general election can’t be excluded.

Short-term exposure is fairly balanced as signalled by front-end risk reversals and the rather narrow range seen this week. Key technical levels that may show whether the UK currency could stage an impressive rally are $1.3564, the 200-weekly moving average, and $1.3637, the 61.8% Fibonacci retracement of its losses since April 2018. Bears may avoid taking profits on shorts until a test of February lows at $1.2773-85.