The pound’s longer, sharper Brexit shock

The result of June’s Brexit referendum was a shock for the foreign exchange markets, one of the biggest ever. It is now clear that the news at the beginning of this month that new prime minister Theresa May was prepared for a “hard Brexit”, forsaking access to the EU single market in return for taking control of immigration, has administered an even greater shock.

Sterling’s decline this month has been gradual and inexorable — barring the spectacular technical glitch in early trading on Friday — and reflects a steady loss of confidence. Perhaps the best way to measure this is by comparing the price of UK government bonds with other developed countries, using a common currency. This eliminates the distorting effects of the fall in sterling that have led some to claim the strong performance of UK stocks in sterling terms is a sign that Brexit is popular with the markets.

Judged this way, the Bloomberg Effas indices show that long-dated gilts have now returned almost nothing for the year, against an 11 per cent gain for US treasuries. As the chart shows, the gap is now even wider than it was in the immediate aftermath of the referendum.

In the summer, the realisation that Article 50 had not been triggered, that the Brexit process could take many years and might even never happen, helped UK bonds to stabilise and catch up all their lost ground. Only a month ago, gilts had returned more for the year than Treasury bonds.

The sharp one-off fall in sterling in the small hours of the referendum morning acted as a shock absorber, while the Bank of England’s decision to ease monetary policy further eased pressure. So did the surprisingly quick resolution of the Conservative party’s leadership contest, while investors were cheered by the victory of Mrs May, who had opposed Brexit in the referendum.

Her speech to the Conservative party conference last week seems to have dispelled almost all the hopeful assumptions that allowed UK assets to recover. Just as investors were wrong to assume that the UK would vote against Brexit, they were also wrong to assume that politicians would ensure a market-friendly Brexit. The Conservatives’ calculation, quite possibly correct, is that a crackdown on immigration, at whatever cost, is a political necessity.

It is not the first time that political talk has had such a devastating effect on a currency. Sterling’s previous all-time low, in early 1985, came after Margaret Thatcher’s press secretary assured journalists off the record that there would be no further interest rate rises to defend the pound. The last sell-off of world stock markets following the Lehman bankruptcy in 2008 came after Timothy Geithner, freshly installed as the US Treasury secretary, made a speech in which he dashed market hopes that the new administration had a plan to end the crisis.

Devaluations can of course be beneficial. The UK certainly benefited from the fall in sterling that followed its ejection from the European exchange rate mechanism in 1992. And it is perfectly possible for a change in political course — particularly a generous negotiating stance from the EU — to send the pound back upwards very swiftly. The sharp sell-off in sterling in many ways represents a challenge by the forex markets to the UK government; it is possible that the government will back down.

For now, however, sterling has very few buyers. Markets are at last resigning themselves to the idea that Brexit means a particularly hard form of Brexit, and that it is really going to happen.

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