Markets are underestimating the possibility that a trade agreement between the U.K. and the EU ends up resembling the much-feared "no-deal" scenario, some strategists say.
The U.K. will officially leave the bloc at 11 p.m. London time on Friday, and both sides will then begin efforts to negotiate a new free trade agreement before the end of 2020. Little price movement is expected on the night, but the cloud of uncertainty is unlikely to lift for now.
Sterling rallied in December after U.K. Prime Minister Boris Johnson's Conservative Party won a significant majority in parliament, enabling the passage of the Withdrawal Agreement and effectively ending fears of a damaging "no-deal" departure.
The pound was trading at just below $1.31 on Thursday after the Bank of England opted to hold interest rates steady.
However, State Street Head of Macro Strategy Lee Ferridge told CNBC that the market is underestimating the potential for any trade agreement between the U.K. and the EU to be "not a lot more than WTO (World Trade Organization) rules," therefore almost equivalent to the no-deal scenario.
"I still don't think the market is really factoring in that in theory the no-deal risk is gone, because there is a deal now, but when we were talking about the no-deal Brexit, what people were really talking about was 'what's the trade agreement? What is the future trade relationship?'" Ferridge told CNBC on a phone call Wednesday.
With Johnson's platform of regulatory divergence and a refusal to extend the transition period beyond December 2020 yielding electoral success, Ferridge said the prime minister would be "emboldened" in negotiations, while the EU would not want to grant the U.K. a "sweet deal" for fear of bolstering the case of Euroskeptics in other member states.
The Bank of England on Thursday forecast anemic U.K. GDP (gross domestic product) growth of 0.8% in 2020, and Ferridge suggested that with uncertainty over trade keeping investment levels low, any concern over a breakdown in negotiations could send sterling back to the low 1.20s against the dollar.
"We're around $1.30 now, we've been down to the low 1.20s before when people were worried about the no-deal Brexit, but if the realization is that really there isn't going to be that much of a free trade agreement - it's going to be less access to the single market than Canada has at the moment - then there's got to be every risk that sterling falls back to those low 1.20s we saw before, particularly if growth stays low."
The Telegraph newspaper reported on Thursday that Johnson would use a major speech to outline that sovereignty is more important than frictionless trade. Brussels, by contrast, has suggested that the U.K. must accept EU standards on goods and products in order to maintain frictionless trade.
"Insofar as the transition phase is due to end on December 31 2020, there is clearly a lot of ground to be covered by the talks in a very short period of time," Rabobank Senior FX Strategist Jane Foley said in a note Thursday.
"The risk for the U.K. economy is that there may be a bad or even a 'no deal' outcome. Such a result would clearly worsen the outlook for the U.K. economy and accentuate speculation about the extent of further monetary policy accommodation."
Foley anticipated that Brexit will continue to "haunt" U.K. investors in the coming months, and projected that the sterling rally on the back of the BOE meeting could be "short-lived," with GBP/USD sliding below $1.30 on both a three and six-month horizon.
The Bank of England cited its reason for holding rates as a perceived economic pickup derived from promising survey data in January, and some analysts have suggested that with a lengthy negotiating process ahead, the pound may reattach itself to traditional economic indicators, rather than Brexit. For Ferridge, the two will remain linked.
"There is a feedback loop. If the negotiations don't seem to be progressing and it becomes more likely we get this WTO scenario, then that will soon cut back on investment again which will feed back into the economy. I think the two are interlinked," he said.
Ferridge argued that a widespread market misconception is that fair value for sterling is in the mid-to-high $1.40s, the range experienced prior to the Brexit vote in June 2016.
"A lot of that is predicated on this view that sterling is cheap, if no-deal is off the table then sterling should rally back to pre-referendum levels, and I just think that's wrong. On our data, we think fair value against the dollar is around 1.35, fair value for sterling against the euro is around 0.86, so sterling is slightly overvalued against the euro.
Sterling was up 0.4% against the euro on Thursday afternoon, with EUR/GBP trading at around 0.8418.