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Analysis and opinion 29 Jun 2016

Brexit opens Pandora’s box for sterling

June 23rd was a historic day for Great Britain and Europe as a whole. No large country has ever before decided to leave the European Union. It remains to be seen what the consequences will be for the local and global economy, labour market, and UK trade position.  What we do know is that Brexit victory is having an immediate effect on the British Pound and equity markets, sterling is plummeting and traders around the world are trying to make the best of it.

On the day of the Brexit results the pound dropped to its lowest level vs. the US dollar since 1985 and fell as much as 8%  vs. the EUR while 10 year UK gilt yields crashed to record lows. BBVA’s analyst see further sterling weakness being difficult to prevent, as political risks have surged after England’s Prime Minister Cameron tendered his resignation and SNP leader Sturgeon has already said that another Scottish independence referendum is now “highly likely.” In the short term, the negative risks related to the UK leaving EU could weaken the pound further. Domestically, not only are Scot’s independence risks intensifying, but the Bank of England may also undermine the GBP if it follows through its recent warnings of cutting UK interest rates and providing extra monetary stimulus.

In the light of the multitude of uncertainties that stems from Brexit, real money outflows from GBP assets may swiftly emerge, putting the GBP at risk of extra slippage in the short-term.  The UK has entered Brexit with the current account deficit being above 7%, a post-World War II record. Sterling is especially at risk from this deficit not being recycled by the previously large net inflows of capital seen in recent years. The UK was for example the world’s number three net recipient of fixed investment (beaten only by the US and China last year). If such flows decline because of the trade related uncertainties caused by Brexit, the GBP could weaken on a medium term as well as short term basis.

In currency market, the risk from a post-Brexit rise in net outflows is especially risky for the pound against the USD, and for major currencies that are typical safe-havens such as the Japanese Yen and Swiss Franc.

In light of these factors, BBVA Global Markets Research estimates that the pound will lose about 15% in value from its pre-referendum position during the next 1-2months, before it can hope to stabilise against the USD. Finally against the EUR we see the pound remaining about 10% lower. But the risk in both cases is to the downside for the pound with Scots independence being a particularly harsh further negative risk to sterling.

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