The British pound and uncertainty are clearly not friends

UNITED KINGDOM – JUNE 19: Confrontation fight between a playful Springer Spaniel dog and a wary frightened cat in a garden in England (Photo by Tim Graham/Getty Images)

There’s nothing like a bit of political and economic uncertainty to spark a selloff in the British pound, as shown in the chart below from Goldman Sachs.

It’s the UK uncertainty index, a construct of economists Scott Baker, Nick Bloom and Steven Davis, that goes back 100 years. Goldman has shaded in periods of substantial pound weakness to demonstrate not only its relationship to a lift in economic and political uncertainty, but also that uncertainty “seems to lead the currency”.

With uncertainty at unprecedented levels, and the prospect of a so-called “hard Brexit” becoming a reality, Goldman suggests that there’s likely to be further weakness for the pound before the year is out.

“Based on our benchmark model that assesses the impact of political uncertainty on currencies, the cumulative depreciation of Cable could be as large as 25 percent by year-end, an additional 7 percent decline from its current value,” says Goldman.

While this is purely based on modelling and “subject to the usual degree of model uncertainty”, Goldman says that “additional considerations lead us to think that such a downside move in Sterling is quite likely to materialise over the next couple of months”.

Here’s the five considerations it says bolsters the case for further pound weakness:

  • First, while difficulties and hostilities around the process of negotiating Brexit have come to the forefront in the past week, in our view, the negative news has not yet been fully reflected in FX.
  • Second, we expect data to deteriorate over the next year, surprising more to the downside than it has done so far, also weighing negatively on the currency.
  • Third, we expect that monetary and fiscal policy will continue to place more weight on economic activity than on inflation; hence, policy news will be at worst neutral and at best negative for the currency.
  • Fourth, the repricing of a policy rate hike in December by the Fed and the USD strength associated with it can also contribute to Cable downside.
  • Finally, at the current juncture, we continue to think that, despite the large current account deficit, the UK will not face a balance of payments crisis of the type seen in emerging markets. A sudden stop of capital inflows forcing a much larger devaluation of the currency is unlikely, as long as the UK’s rule of law and institutions remain stable and business friendly. That said, even without a balance of payments crisis, we show below that there have been eight episodes in the UK where the currency depreciated by 25 percent or more over a period of less than a year, even though in many of these cases the exchange rate regime was either fixed or pegged, and the UK government either moved to a flexible regime or announced a one-off devaluation.

NOW READ: This table from HSBC explains the difference between a ‘hard’ and ‘soft’ Brexit

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