Lee Hardman, Currency Analyst at MUFG, suggests that the pound’s sharp decline early this year has resulted in cable falling below the 1.4000-level for the first time since March 2009 which was during the peak of the global financial crisis. Key Quotes “Cable has now fallen by almost 10 big figures so far this year with the rate of decline running at annualized rate of around -30%. It is an increasingly rapid pace of decline for the pound but still falls well short of the sharp declines recorded during the global financial crisis and following the UK’s decision to suspend its membership of the European Exchange Rate Mechanism in September 1992. The warning from history is that pound weakness could accelerate further which would be likely in the event of Brexit. The pound continues to be undermined as the market discounts a higher Brexit risk premium ahead of the EU referendum. In this respect the increasingly negative financial market headlines that the pound is plunging ahead of the referendum will not help the Brexit campaign to reassure the public that the UK will be better off economically outside of the EU. The UK economy has been driven by personal consumption growth which would likely weaken as a result from the squeeze on real incomes from a weaker pound as it helps to lift inflation. A further sharp decline in the pound would reinforce the hit to disposable incomes especially if wage growth remains subdued. The scope to ease planned fiscal tightening to support growth is limited given that the budget deficit remains elevated at around 4% of GDP. The burden would likely fall more heavily on the BoE to provide support for economic growth through easing monetary policy further. In these circumstances, we continue to believe that the pound can still weaken further and become more volatile as we move closer to the referendum. The pound has already weakened sharply to discount a larger Brexit risk premium. We estimate roughly that the pound is around 5-10% weaker to account for the Brexit risk premium. Yet there is still clearly scope for further pound weakness as the risk of Brexit is far from fully priced. The trade-weighted pound has so far declined by around 9% from its peak in August of last year reversing around half of its gains since early in 2013. However, it still remains around 15% higher than the lows recorded during the global financial crisis and following the UK’s decision to suspend its membership of the European Exchange Rate Mechanism in September 1992. In the event of Brexit, a further 10-15% decline appears a reasonable assumption which would return the trade weighted pound towards previous lows. According to our long-term valuation estimates the pound is already significantly undervalued against the US dollar by around 15%. A further 10-15% decline into the mid–to-low 1.2000’s would leave cable more extremely undervalued. As a result, valuation could become more restrictive helping to dampen the scope for further cable downside. We expect the pound to weaken further as well although to a lesser extent against the euro given the potential negative spill-over impact from Brexit on Europe. EUR/GBP would likely rise closer towards the 0.9000-level. According to our long-term valuation models, the pound is more modestly undervalued against the euro. However, in our base case scenario we continue to expect the UK to vote to remain within the EU. We have not changed our view based on recent developments. If the UK votes to remain within the EU, the pound is likely to rebound following the referendum as the Brexit risk premium is removed. The more the pound weakens in advance of the referendum, the more sharply it could rebound following the referendum assuming that heightened Brexit uncertainty doesn’t have a more lasting negative impact on the UK economy. In our latest forecasts, we projected that GBP/USD could fall to as low as 1.3000 during Q2 before ending the quarter at just above the 1.4000-level following the referendum on the 23rd June. We remain comfortable with that outlook. In contrast, upside risks have increased to our forecast for EUR/GBP to fall back to the 0.7300-level by the end of Q2. If EUR/GBP continues to climb into the low-to-mid 0.8000’s in advance of the referendum, our forecast for the end of Q2 will be more challenging although still not impossible to achieve.” For more information, read our latest forex news.