Sterling's rocky week: Where may the pound go next?

Where sterling goes from here is anyone's guess. But where politics goes, the pound will too.

Sterling has had a wild ride this week. At the start of the week, fears that the UK would end up leaving the European Union on October 31 without a deal saw the pound fall to just $1.19. But by mid-week, those fears have faded somewhat, following Parliament agreeing to a new bill designed to avert a no deal Brexit. As a result, the pound has now rebounded to $1.23, the highest level since late July.

As Trevor Greetham, head of multi asset at Royal London Asset Management, the drama in British politics this week pushed sterling volatility to a level only once exceeded since the 2016 referendum. He says:

"To put this in context, the pound is now almost as volatile as the stock market, a very unusual state of affairs for a developed economy."

Three month implied volatility of the sterling/US dollar exchange rate

The pound appears to have stabilised for now. However, argues Pantheon Macroeconomics, for the time being it is difficult seeing the sterling appreciate much further. They argue: "The rebels have bought only three months' breathing space.

"The extension is not long enough for the economy to recover, for the Monetary Policy Committee to consider raising Bank Rate, or for overseas investors to give UK assets a fresh look."

Where sterling goes from here is anyone's guess. But where politics goes, the pound will too.

Greetham says that any event that makes no deal appear more likely will likely lead the pound lower, while any move towards a deal being agreed upon or ending the prospect of Brexit would lead the pound higher.

Pantheon Macroeconomics argues similar, noting: "The potential upside for sterling, in the event that Brexit is scrapped or is so soft that it has a negligible economic impact, remains substantial." The economics consultancy predicts the pound to rally to $1.32 should Brexit risks "fade to zero."

Of course, predicting which outcome will be decided is almost impossible.

The big unknown, however, is a general election. This, says Greetham, would bring a new bout of volatility. He argues:

"There is little prospect for a new deal with the European Union under the short timetable currently available so the markets would probably be forced to factor in a no deal Brexit under a majority Conservative government."

At the same time, fears of anti-business policies from a Labour government would also spook markets. Greetham says:

"Arguably the pound would rally most on a hung parliament with centre parties including the Liberal Democrats needed to form a government."    

Pantheon Macroeconomics points out that the Conservative Party is still leading opinion polls, with 35% of voters saying the intend to support the Conservatives. "That's the highest level of support for the Conservatives in a YouGov poll since mid-March," they point out. Meanwhile, Labour and the Lib Dems are polling 25% and 16%, respectively.

The Conservtive Party winning a new majority would reignite the prospects of a no deal, to which currency markets will respond negatively.

However, the consultancy only gives the Conservative Party a 35% chance of winning an election, citing the probability support declining during the course of any campaigning. Instead, Pantheon predicts a hung-parliament.

The consultancy concludes: "All told, we retain our medium-term view that sterling is undervalued and think that the election will not lead to a majority emerging in favour of a no-deal Brexit.

"A series of rolling Brexit extensions remains the most likely outcome. That would allow sterling to recover eventually towards the $1.30 region by the very end of the year, though given the downside risk posed by an outright Conservative win, a further meaningful recovery isn't likely over the next month."

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