Tue, 17 Sep 2019

Since Boris Johnson took over as prime minister of the UK, the pound has crashed in value compared with the US dollar. The implication is that as a no-deal Brexit appears increasingly likely, international financial markets are getting more and more nervous about Britain's economic prospects for the future.

We have analysed the trends in the value of the pound using what is known as a GARCH model. This takes into account past values of the currency as well as its volatility. Currency volatility is important as well as trends because it is a direct measure of market uncertainty, and since Johnson entered Downing Street volatility has greatly increased.

The modelling shows that there has been a predictable decline in the value of the pound every successive day since the European elections on May 26 2019 and particularly since Boris Johnson entered Downing Street on July 10 2019. In other words, if the chances of a no-deal Brexit continue to rise then there is money to be made by currency traders riding a predictable trend.

When shorting makes sense

In normal times, currency values are relatively unpredictable since they follow what statisticians call a "random walk". This means that today's value of the pound depends on its value yesterday plus a random "shock" term which can be positive or negative. The shocks occur because financial news is emerging all the time and some traders react positively to it and others negatively. When the pessimists outnumber the optimists the pound falls in value.

Read more: Brexit uncertainty has hurt UK economy - extending Article 50 could hurt it even more

Every so often a "sure thing" comes along when the markets decide that the price of the currency is going to change in only one direction because there is a consensus about the economic consequences of particular events.

For example, on "Black Wednesday" - September 16 1992 - the pound was ejected from the European Exchange Rate Mechanism, the predecessor of the euro currency zone. Despite attempts by the then finance minister, Norman Lamont, to hold the pound stable by increasing interest rates, Britain crashed out anyway as the traders had predicted. This had the effect of destroying the Conservative Party's reputation for economic competence overnight and they did not regain it until David Cameron became party leader in 2005.

If there is a no-deal Brexit, then markets are likely to react in a similar way as they did on Black Wednesday in 1992 and the pound will crash in value. Consequently traders will be "shorting" the pound, which is when they offer to sell pounds for delivery after the Brexit deadline at a fixed value that they are likely to profit from. For example, they could offer to sell the pound at its current value of around US$1.21, for delivery on November 1, the day after Brexit. They then wait for the currency to fall and buy it on the spot market, where trades take place immediately - thereby pocketing the profit from selling them at US$1.21, having bought them at a much lower rate.

The interesting thing about this dynamic is that it becomes a self-fulfilling prophecy if enough people believe it is going to happen.

Can a no-deal Brexit be stopped?

Needless to say this strategy will fail if a no-deal Brexit does not occur. To that end Jeremy Corbyn and the Labour Party have offered to run a "caretaker" government for a fixed period of time in order to stop this from happening. They have appealed to dissident Conservatives, the SNP and the Liberal Democrats to support them in a vote of no confidence against Boris Johnson's government, prior to setting up this caretaker government.

Nicola Sturgeon, SNP leader, has offered her party's support: "We will work with anyone at Westminster to try stop Brexit, and avert the catastrophe of a no-deal Brexit."

Those puzzled by John McDonnell's recent revelation at the Edinburgh festival that Labour might not obstruct a bill to allow another Scottish independence referendum will now understand what is going on. It may have provoked a row with the Scottish Labour Party, but it may have helped to get the SNP on board.

Read more: Jeremy Corbyn's unity government plan: these are the numbers he would need to block no-deal Brexit

The surprise was that the new Liberal Democrat leader Jo Swinson initially ruled out any deal with Labour, calling Jeremy Corbyn "divisive". A relatively inexperienced new leader, this could be because she is flushed with the success of her party in the recent European elections. But she subsequently backed away from this hard line and agreed to talk to Corbyn. Meanwhile, there is also a question mark about Conservative Remainers backing a Corbyn government.

But opposing the Corbyn initiative may be a fatal mistake for Remainers in parliament if it torpedoes what eventually turns out to be their last chance to prevent a no-deal Brexit. There are other options on the table for doing this, such as seizing control of the parliamentary agenda to block it, or forming a caretaker government with a consensus prime minister such as Ken Clarke in charge. But at the moment it is not clear if they are more likely to be successful than a Corbyn government.

It would be a true irony if the currency traders set to make a killing from a no-deal Brexit will have the parliamentary Remainers who cannot get their act together to thank for their bonuses this year.

Authors: Paul Whiteley - Professor, Department of Government, University of Essex | Harold D Clarke - Ashbel Smith Professor, University of Texas at Dallas The Conversation

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