Currency analysts are predicting a volatile period of trade for sterling as the British government races to agree a crucial Brexit deal ahead of an EU leaders' summit later this month.
The pound continued its slide Tuesday morning on news that a nearly-achieved deal had fallen through over disagreement on the question of the Irish border.
Sterling was trading at around 1.3400 against the dollar at 9:00 a.m. London time, down from a session high of 1.3523 Monday afternoon when early reports from Brussels suggested that Theresa May's U.K. government had agreed to a deal with the EU that would pave the way for future trade talks. The U.K. has to clear certain key issues before both sides can start discussing a possible trade deal.
Monday's agreement involved a U.K. concession that its province of Northern Ireland would remain in the EU customs union, preventing a hard border with the Republic of Ireland.
The potential deal was then derailed at the last minute by Northern Ireland's hardline Democratic Unionist Party (DUP), on which May's government relies for support. The pro-Brexit DUP staunchly rejected the agreement, refusing to be subject to different terms from the rest of the U.K.
The day was closely watched by markets as May met with EU leaders Jean Claude Juncker and Donald Tusk in Brussels to try to settle terms of Britain's "divorce" from the EU.
"Despite our best efforts and significant progress … It was not possible to reach a complete agreement today," EU Commission President Jean-Claude Juncker said Monday. "This is not a failure; this is the start of the very last round."
The U.K. currency remains volatile ahead of the upcoming EU leaders' summit on December 14. And in the immediate term, analysts do not see a positive trajectory for sterling until a clear path to trade talks is apparent.
The DUP provides essential political support to May's government in what's called a "confidence and supply" arrangement, which enables the prime minister to maintain her majority. This essentially means that May must keep the DUP happy, or it will threaten to withdraw its support.
"A fresh election in the U.K. would introduce a wide range of new uncertainties for investors," Simon Derrick, chief currency strategist at BNY Mellon, told CNBC via email. "Given the current uncertainties, I think GBP weakens into year end," Derrick concluded.
In the case of there being no transition to trade talks, Stephen Gallo, European head of FX strategy at Bank of Montreal, sees sterling moving back to the 1.3100/1.3200 level over the near term. Gallo believes that any positive U.K. economic data will provide very little support for the pound. "We need to clear the Brexit hurdles first before the FX market can respond to better economic data," he said.
Meanwhile, Kallum Pickering, senior U.K. economist at Berenberg, suggested: "A potential solution would be for the U.K. as a whole to agree to regulatory alignment with the EU in the markets it wants to trade in after Brexit. To secure a deep free trade agreement, that will more or less have to happen anyway. It is just that May probably isn't ready to admit that just yet, fearing a political backlash, after signing off the Brexit bill last week."
Once the U.K.'s divorce from the EU is settled, Pickering expects a gradual improvement in market expectations for U.K. growth and a notable reduction in uncertainty. He sees sterling at 1.41 against the dollar by mid-2019, just after Brexit.
The U.K. and EU have been at odds over the outcome of the Irish border, with Dublin strongly opposing a potential hard border separating Ireland and Northern Ireland over fears it could undermine the 1998 Good Friday Agreement, which ended three decades of sectarian violence.
"A failure to resolve (the border issue) in a way that ensures the Irish government will not veto the broader Brexit negotiations moving on to the next stage would leave investors highly uncertain about the final shape of Brexit in Spring 2019," Derrick said.