One Year On, the Pound Can't Shake Brexit Blues

Political anxiety has dragged on the British pound in the year since the Brexit vote. But now a shaken power structure in Westminster and a central bank divided by economic cross currents have investors debating whether the beleaguered currency has further to fall.

Last June, the U.K. voted to leave the European Union, and the pound tumbled 11% in a matter of hours.

Since then, political uncertainty and concerns that leaving the EU will dent economic growth have continued to weigh down the pound. Despite rising slightly this year, it currently trades at around $1.27, compared with $1.50 before the referendum result.

Many feel it has further to fall but are reluctant to place large bets given the uncertain political and central bank outlook in the U.K. Inconclusive elections earlier this month opened up the possibility of the U.K. maintaining closer-than-expected ties with the EU, but also fueled worries the prime minister will be seen as a less reliable interlocutor, increasing the chances the talks could end without a deal.

Meanwhile, as the bulk of the developed world grapples with accelerating growth and signs of tepid inflation, the U.K. is experiencing inflationary pressures and signals of a slowdown in the economy.

Weak growth and building inflation have made life complicated for Bank of England policy makers, who are increasingly at odds over whether to raise interest rates in response to higher inflation.

"I think the U.K. will face a headwind to growth later this year as Brexit concerns strangle things," said Alan Wilson, investment manager at State Street Global Advisors.

Investors say that politics, and specifically Brexit, will be the major driving force behind the pound's long-term path.

The U.K. opting to maintain a close relationship with the EU could see sterling swing higher, they say. Some investors believe the recent election result has made that outcome more likely. The ruling Conservative Party, which had campaigned for a clean break with the EU, lost its majority in parliament and is now reliant on other parties to pass legislation.

But Britain's two main political parties say they remain committed to Brexit. Many still think sterling will suffer as the Brexit negotiations move forward.

"Sterling hasn't bottomed yet," said Marc Chandler, global head of currency strategy at Brown Brothers Harriman, predicting it could eventually fall to parity with the dollar. "Brexit will make the U.K. smaller and weaker."

Over the nearer term, the pound's trajectory will largely depend on how the Bank of England addresses the simultaneous rise in inflation and slowdown in economic growth.

U.K. consumer prices climbed in May at the fastest annual rate in almost four years, with a weak pound leading to higher import prices.

Economic growth held up well in the latter half of 2016, defying the dire predictions of many analysts. But growth slowed in the first quarter of the year on weak consumer spending. Some economists believe that could be a sign of things to come.

Researchers at industry trade group Institute of International Finance forecast quarterly U.K. growth will slow to near zero this year as businesses put off investment decisions and consumers are hit by declines in real wages. Brexit negotiations are likely to be tough and uncertainty will remain high throughout, they argue.

Inflation-targeting central banks typically raise interest rates to tamp down on price rises. Higher rates would typically boost the currency, as investors are encouraged to buy higher-yielding sterling-denominated assets.

But the increase in U.K. consumer prices is mainly down to the weak currency boosting import prices rather than rising wages and an expanding economy. The BOE cut interest rates and boosted its bond-buying stimulus programs following the Brexit vote to support the economy, and policy makers are now wary of lifting rates in a way that could stifle growth.

Communications from Bank of England officials reveal this conflict. The BOE's rate-setting monetary policy committee voted to hold rates steady at record lows last week. But three out of the eight-member committee voted for a rate rise, up from one person at the previous meeting.

Andreas König, head of foreign exchange in Europe for Pioneer Investments, says it is hard to find any reason to bet on the pound rising over the longer term due to the U.K.'s economic position and the uncertainty over Brexit. But he is wary of betting on its decline given he thinks the BOE's recent comments show it will intervene verbally to prop up the currency.

"Lower sterling makes sense fundamentally, but from a risk-reward perspective it's not very attractive," he said.

Others are still betting on declines. Bearish bets against the pound have increased for a third week, according to CFTC Data, with net speculative positions on the currency remaining in negative territory at all times since the vote. Many believe the lack of clarity over the U.K.'s relationship with the EU will continue to cloud the picture.

"It's difficult to see sterling making significant gains until the political uncertainty here is cleared and we can see a clearer path to how Brexit negotiations will work themselves through," said Simon Derrick, chief currency strategist at BNY Mellon.

Write to Riva Gold at riva.gold@wsj.com and Christopher Whittall at christopher.whittall@wsj.com

(END) Dow Jones Newswires

June 23, 2017 00:14 ET (04:14 GMT)