FxWirePro: Hard-Brexit, BoE shift in easing cycle, FI market and May’s speech stimulate sterling’s vulnerability

The sterling came under notable pressure yesterday ahead of the hearing of Bank of England governor Mark Carney in front of the House of Lords’ committee.

While the long-term sterling bonds suggest investors are quickly losing confidence in the Bank of England’s ability to support debt markets through the U.K.’s departure from the European Union.

The bond sales took place after the central bank announced plans in August to buy corporate debt, sparking investor optimism. The mood has since soured because of concerns about a so-called hard Brexit, sterling’s tumble and the outlook for inflation.

The market was more focused on the Bank of England’s support rather than the longer-term Brexit risk.

Companies sold about 4 billion pounds ($4.9 billion) of bonds maturing in 20 years or more in the two months after the BOE’s Aug. 4 stimulus announcement. That’s almost double the tally for the first seven months of the year. Issuers rushed to market as the BOE’s bond-purchase plan and an interest-rate cut helped push corporate borrowing costs to a record-low 2.06 pct.

May Speech as additional booster of GBP slumps:

The speed at which sterling has devalued has surprised people if you bought into these deals in August, and you’re a total-returns investor, you’re hurting.

The yield on 10-year U.K. government notes has surged to about 1.08 pct after the PM Theresa May made a speech at a Conservative Party conference the following week suggesting she favored a hard Brexit, which may entail leaving the single market as well as the EU.

The pound dropped below $1.21 to the lowest level since the ‘flash crash’ earlier this month, as markets took note of Chancellor Hammond’s comment that he sees no reason to refuse a request by the BoE for more QE. Some of the decline reflected broader US dollar strength as the probability of a hike this year rose. Sterling pared some of its fall after BoE Governor Carney’ said that there are limits to the willingness to overshoot the inflation target and officials were not indifferent to the exchange rate.

A pickup in inflation to hurt long-term bonds because it reduces the relative value of future fixed-income payments.

The fact that only such a weak cause was required to cause such a pronounced Sterling move constitutes a warning signal. This time round luck may have been on Sterling’s side as the fundamental weakness turned out to be unjustified and Sterling was able to retrace some of its losses as a result.

But what will happen when the British government activates article 50 of the TEU and Brexit finally becomes concrete?

There is a high likelihood that at the start of the negotiations both sides, i.e. the British government and the EU 27, will pursue a tough stance so as to achieve the best possible deal for themselves. If concerns about a “hard” Brexit should then meet a liquidity gap Sterling depreciation may not only turn out to be much more pronounced but could turn into a self-reinforcing downward spiral.