Tensions over the UK’s trade talks with the EU have hit sterling hard for the second consecutive day as traders bet that the Bank of England may have to cut interest rates to cushion the economic blow of a disorderly Brexit.
The pound dropped almost 1 per cent against the dollar to hit a low of $1.3043, taking its losses so far this week to 1.74 per cent after the Financial Times reported that the UK could tear up elements of its EU withdrawal agreement, which led to the resignation of a top government lawyer the following day.
Ahead of the start of the latest formal round of trade talks later on Tuesday, Prime Minister Boris Johnson expressed support for leaving the EU’s single market and customs union without a trade agreement and suggested that unless a deal is agreed by October 15, the two sides should “move on”. The one-year transition period for the UK’s exit from EU trade structures expires on December 31.
“The willingness for compromise seems worryingly low,” said Claire Dissaux, head of global economics and strategy at Millennium Global Investments.
The decline snaps a winning streak for sterling, which has pushed higher against the struggling dollar. By the start of this month, it had reached its strongest levels of the year above $1.34, comfortably wiping out the decline experienced in the depths of the coronavirus crisis in March.
But Brexit is now back as a clear drag on the currency.
“As the focus shifts back to the negotiations, investors will be reminded that the most likely outcomes here are for either a bare-bones Brexit or a ‘no-deal’ exit, neither of which look constructive for sentiment on UK growth and assets,” said Paul O’Connor, head of multi-asset at Janus Henderson.
“It would be no great surprise if [this] drop in sterling was the start of a more meaningful move lower,” he added.
Options markets reflect expectations that the rest of this year will be rocky for the pound. Lee Hardman, a currency strategist at MUFG Bank, said market pricing still suggests that investors believe that a deal can be struck at the last minute, based on the view that neither side wants to risk an economic shock following the coronavirus crisis.
“We now expect that optimistic view to be tested more thoroughly in the coming months,” said Mr Hardman.
The latest slide in the currency came as bond markets moved to price in a potential response to a no-deal Brexit from the BoE. A rally in short-dated government debt, which is highly sensitive to BoE policy, pulled two-year borrowing costs to an all-time low of minus 0.14 per cent.
“Lack of progress in Brexit talks is likely to push gilt yields lower, because investors think it makes rate cuts more likely,” said Theo Chapsalis, head of UK rates strategy at NatWest Markets.
Derivatives contracts linked to short-term interest rates show that investors are now fully pricing in a reduction in BoE rates to zero — from 0.1 per cent currently — by February, and a growing chance of negative interest rates later next year.