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05.07.2016 06:11

Risk of a drop to 1.25. Sell any Gbp/Usd rallies - BofA Merrill

"Rarely in UK political history has there been a situation where there has been a concurrent leadership contest in the two largest parties in Parliament. In our pre-Brexit notes, we had outlined our concerns over the political ramifications at the top of the ruling Conservative Party irrespective of the outcome as the party was already split on whether to Remain or Leave. What we did not foresee was crisis engulfing the opposition Labour Party in its own political crisis. Whilst this may seem like a sideshow against the broader debate on the EU, we think this has important implications in the ability of the Labour Party to mount a credible opposition to the government when negotiations eventually begin. This is particularly relevant given that there has been increasing chatter in the media on whether Article 50 will be activated or if indeed the UK will actually trigger a Brexit.


One of the most common questions we have received in recent days is whether there could be a General Election or second referendum, which could open a route to the UK remaining in the EU, or at least seeking a 'Norway-style' trade deal that preserved single market access. A General Election is clearly a possible scenario but there is a long way to go before we have a good sense on what it would mean for economics and markets. Another referendum also seems unlikely to us at this stage. Both David Cameron and Jeremy Corbyn, along with other politicians, have been clear in recent days that they would accept the public's decision to "Leave" and this has been reinforced by Theresa May in her speech announcing her candidature for the Conservative Party Leadership. Our caveat to this assumption is if the economic fallout from the referendum is significant.


Given some expectation that a Brexit may in some way be avoided, would suggest that markets are not fully positioned for this prospect and may go some way in explaining why GBP is off its lows from last Friday.


In our view this poses risks to further downside in the pound as it eventually becomes apparent that Brexit is the only option on the table. But the bounce that we had expected following the sharp fall has materialised and we reiterate our view that GBP is vulnerable to further losses as the political vacuum heightens policy uncertainty.


We are therefore inclined to sell any sterling rallies and affirm our view that the Brexit vote now implies a structurally lower equilibrium value for GBP. We see risks of a move towards 1.25 in GBP/USD sooner rather than later".

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