What Kind Of Brexit Is Priced Into GBP/USD?

The United Kingdom is expected to leave the European Union next March 29th, but as of now, no Brexit deal has been reached and approved by the UK Parliament. Next Tuesday, January 29th, a Plan B presented by PM Theresa May is set for debate and vote. Prior to it, our staff of chief analysts discusses the different scenarios and endless possibilities that this ongoing political situation might bring, analyzing prospects for the Pound. So, what kind of Brexit is priced into GBP/USD?

What kind of Brexit is priced into GBP/USD?

Valeria Bednarik:
Ha! clearly, the market firmly believes that the UK will avoid a hard landing. Either by an extension of the current limbo situation or through a new referendum that could turn things around. Anyway, and in my opinion, this is pure denial: a hard-Brexit is coming.

Yohay Elam:
A hard Brexit is the default option, but there are other scenarios. Why do think a hard Brexit is coming?

Valeria Bednarik:
Because the EU is firm in its posture of "teaching a lesson." I don't know, ever since the Union was made, we have been discussing how "fragile" it is, and about the multiple reforms that are needed, but are still pending. The UK leaving is a "low blow" to the future of the Union. The EU can't allow another exit or make it easy for its members to leave. It would all fall apart. That's why the EU is making it as tough as possible to the UK. What's your take?

Yohay Elam:
I agree the EU wants to punish the UK and teach others a lesson, but they prefer the Brexit deal which is bad enough for the UK and good for the EU than a hard Brexit.
A hard Brexit would also inflict damage to Ireland (first and foremost), France, Belgium, the Netherlands, and also Germany's car industry.

Mario Blascak:
And above all everyone involved realizes how detrimental it would be for the UK to leave the EU with no deal.
The Bank of England estimated four different baseline scenarios for Brexit, with the close economic partnership expectedly resulting in the loss of relative GDP of -1.25% to a -3.75% compared to the level from May 2016, while the worst case (no-transition, no-deal Brexit) could see a relative loss of GDP amounting to -7.75% up to -10.50%.
So a no-deal Brexit, or other hardliners scenario, will be, in my view, avoided.

Valeria Bednarik
Indeed, it would inflict damage to the EU but politicians are taking that cost. And, by the way, the market seems to be blindfolded on how Brexit will affect the Union.

Yohay Elam:
At the time of our conversation, GBP/USD is around 1.2900. In case of the worst-case scenario, a hard Brexit, how low can the pound go? 1.20?
And yeah, as you say, EUR/USD will fall as well. If markets are not pricing a hard Brexit for GBP/USD, the same applies for EUR/USD...

Valeria Bednarik:
Yups, 1.20 is there, because the only thing keeping the Pound afloat is hope. Call me a pessimist, but with 2 months to go, the EU has put a checkmate on the UK and there we go: hard-Brexit.

Yohay Elam:
1.20 was the flash crash low of October 2016 and is also a very round number.

Mario Blascak:
The Bank of England modeled scenario paints much darker picture of Sterling falling 25% in case of disorderly Brexit.

Yohay Elam:
25% is closer to parity from current levels...

Mario Blascak:
The lowest level in 200-years.

Valeria Bednarik:
Well, as I always say, I can't see that far away without my glasses, but for sure, not waiting for Pound bulls to take it nicely.

Yohay Elam:
200 years ago, the post-Waterloo generation.
But didn't the Bank of England go too far?

Mario Blascak:
This is what the mathematical model said, taking into account all the bad assumptions.

Yohay Elam:
The renowned economist Paul Krugman, who can't be blamed for supporting Brexit and is a dove, criticized the BoE and said they went too far.
My guess is somewhere in the middle: 1.10-1.15
I believe that in case of a hard Brexit, central banks will come together to stabilize the situation, at least in the FX market.

Mario Blascak:
That is one of the options.
Common FX market intervention is rare, but happened in the past and certainly belongs to central banks arsenal.

Yohay Elam:
Central banks intervened after the horrific earthquake, tsunami, and nuclear disaster in Japan in March 2011.
A hard Brexit could justify such a cooperation, but it's still a long shot.

Valeria Bednarik:
As long as a second referendum is. And here we are, with the Pound up on Corbyn's proposed amendment about ways to finish the stalemate, that only mentions it as a possibility.

Yohay Elam:
Yep, the amendment provides hope and supports the Pound. But what is priced in?
If there's a second referendum, where can the Pound go?

Valeria Bednarik:
First to "go" will be PM May, as it will be the epitome of complete failure. I can't recall a time, over these last two years, when she didn't say she will deliver as promised. The market could go wild, as relief of no-Brexit will oppose to fears of political chaos. I would say that if a second referendum is confirmed, GBP/USD could jump to 1.45/1.46, pre-2016 referendum levels, only to give up relatively fast good hundreds of pips, back to 1.36/1.37.

Yohay Elam:
I'm eyeing the referendum night level of 1.5000, which is also a round number.
But many other things have changed since then.
I guess it can settle around 1.36-1.37 if a second referendum is approved, and jump to higher ground if Brexit is reversed.
The outcome of such a second vote is up in the air...

Mario Blascak:
The option of second Brexit referendum was accepted by the EU officials as ¨legitimate¨,
therefore we see Sterling on a trade-weighted basis at a 10-week high but still about 10% below the levels at the time of the Brexit referendum on June 23, 2016
So there is certainly a scope for further appreciation.
Although I do not expect the second Brexit referendum to materialize, I agree that Sterling would be initially boosted, even with the result uncertain.

Yohay Elam:
How far do think GBP/USD could go if a second referendum is agreed?

Mario Blascak:
I expect 1.35-1.37, maybe even higher. Markets are irrational.

Yohay Elam:
As Keynes said: "Markets can remain irrational longer than the trader can remain solvent".
Always consider your leverage and trade responsibly.

Valeria Bednarik:
Why are you thinking a second referendum is a bullish trigger? To me, it is a complete UK failure, and the market will well decide to buy the rumor and sell the fact. A second referendum will come alongside a new government, as it is not going to happen with May in charge. So, more delay, new general election, a new government and then probably a second referendum? That can't be bullish for the Pound. Furthermore, consider the market has already priced in some kind of positive outcome, name it as you want it, and in this scenario, political uncertainty will skyrocket.

Yohay Elam:
I think that markets are pricing in a delay of Brexit, but not the chance of it being cancelled.
Another referendum opens the door to a total reversal, something that markets want. If Corbyn is elected, they won't like it, but if the Conservatives remain in power and there's no Brexit, it's a win-win for market. Chances are low, though...
One thing is certain: uncertainty is high. There are countless scenarios, twists and turns.
At the moment, we have the following timeline: Parliament votes on amendments to the Brexit debate on January 29th. Brexit Day, if there's no delay, is on March 29th. The European Parliament elections are on May 26th. But things are fluid, and GBP/USD remains highly volatile.