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Pound’s calm faces test as Brexit talks near

Despite another turbulent few days in British politics, the pound is ending the week on a firmer footing.

Sterling brushed off the latest bout of Brexit nerves and further worries about a break-up of the UK, closing near $1.24 on Friday. Its revival was aided by a dovish Federal Reserve and a hawkish Bank of England.

However, there are still plenty of currency-watchers who see further trouble ahead. Many are readying for another leg down — a drop below $1.20.

Sterling’s first big hit came in the days after the June 23 vote, when it slumped 17 per cent to below $1.30. The second tumble followed in October when Theresa May’s Conservative party conference speech spooked investors, pulling sterling into the $1.25 territory.

Pressure piled up again amid government Brexit drift in January, prompting investors to flirt with $1.20. That was until Mrs May’s Lancaster House speech, which gave the market much-needed clarity on her Brexit strategy and inspired the currency’s mini-resurrection.

Now, as the prime minister prepares to trigger Article 50, the imminent start of formal negotiations for Britain’s EU divorce has several traders wondering whether the time has come to sharpen the knives again.

1. Theresa May’s “citizens of nowhere” speech leads to start of sterling sell-off

2. Philip Hammond and David Davis meet bank chiefs at the Shard in a “reassurance exercise”

3. May’s Sky TV interview leaves markets unimpressed; pound falls again

4. Sterling retreats after Downing Street briefings on May’s upcoming speech on Brexit

5. May’s Lancaster House Brexit speech contributes to pound’s 3 per cent bounce

6. Bank of England meeting prompts sterling fall

Discounting October’s sterling flash crash, “$1.20 is the new level”, says Kamal Sharma at Bank of America Merrill Lynch. He sees the pound dropping to $1.15 over the next three to four months. “We are heading for a critical period for markets — the Article 50 triggering and the EU response.”

That view looked well founded when sterling dropped to only just above $1.21 on Tuesday, its lowest for eight weeks. But central bank decisions on both sides of the Atlantic on Wednesday and Thursday helped the pound reverse course.

Frequent sharp fluctuations like these have forex strategists wondering how much investors have truly factored Brexit into their sterling valuations.

Morgan Stanley, for example, notes how little sterling moved during the parliamentary to and fro over the Brexit bill. Such political developments would last year have been sensitive for the pound, so its strategists conclude that a lot of Brexit uncertainty is now “in the price” of the currency.

Sterling has, after all, traded fairly resiliently in the past five months between $1.20 to $1.27, a range that appeared to solidify once investors accepted that Article 50 would be triggered.

Others are more bearish. George Saravelos, currency strategist at Deutsche Bank, reckons a pound will be worth only $1.06 by the end of the year.

“We think people will realise it will be very, very difficult to conclude a deal within two years and the market will sell on the risk of no deal,” he says. “There is a clear Brexit effect on the economic data and an income squeeze on consumers.”

How could anyone price in Brexit, he wonders. “We can’t define it yet. There is absolutely no precedent for any such event anywhere in the world.”

Mr Sharma concurs. “The market is complacent thinking that Article 50 removes uncertainty” and has not factored in a disruptive start to the negotiations, he says. Similarly, Simon Derrick of BNY Mellon wonders if that Lancaster House speech lulled investors into “a false sense of security”.

However, this week’s price action suggests investors may be waking up to the realisation that sterling is on the cusp of a new, potentially difficult, phase. The pound moved 1 per cent lower at 6am London time on Tuesday, 1 per cent higher at the same time on Wednesday. On neither occasion were the moves triggered by specific Brexit news or data.

“I have never seen it before,” says Antony Foster, who runs Nomura’s G10 forex spot trading, concluding that small shifts in sterling were generating a herd mentality in the market. “It’s jittery. People are playing it very safe, they don’t want any shocks.”

The market, for now, appears relatively sanguine about sterling’s prospects during the two-year Brexit negotiations. Forex analysts polled by Bloomberg on average expect the pound to strengthen to $1.24 by the end of 2017 and $1.29 by the end of next year.

Helping to prop up sterling expectations is a fairly solid UK economy, forecast to grow this year at 2 per cent, and the dollar weakening on Fed dovishness. Richard Benson, portfolio manager at Millennium Global Investments, adds that the currency is “relatively cheap and that’s a positive for sterling”.

Will these factors hold? Watch the data, says Mr Benson. “Trading politics is extremely difficult and this week has proved that. It’s more important to follow the cyclical dynamic, which has shown signs of softening.”

Investors would be wise not to rush to judgment. BNP Paribas thinks European elections will hold up Brexit negotiations, so in the absence of new information investors might unwind their short sterling positions and the pound will “grind higher”.

Sterling may have sailed through choppy waters this week, but even the optimists see further turbulence just across the horizon.

Additional reporting by Alice Ross

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