Nomura - Pound is set for weakness again

Declines in the pound sterling could accelerate as political instability in the euro zone increases, potentially hurting the British currency more than the euro, Nomura said in a note on Monday.

The euro tends to depreciate much less against the pound when the popularity of the anti-establishment parties rises," Nomura said, noting the effects are usually seen against the dollar and the CHF. "This means pound depreciation against USD could accelerate when political instability in the key euro area nations increases."Nomura pointed to three main euro-centric forces as likely to weigh on GBP ahead: U.K. external deficit financing was set to become more difficult, the British economy could lose momentum and the possibility that EU governments would pursue a "hard Brexit" could become more likely.

Several important votes are coming up on the continent, with the emerging possibility that voters in more countries will upend established political norms to express anti-union sentiment.On December 4, Italy will hold a referendum on reforming its constitution to restructure the legislative process to speed the passage of laws. A defeat in the referendum for Italy would be perceived as a victory for anti-European sentiment and could lead to social turmoil in other countries that are already facing a strong resistance to changes, with elections across Europe that will take place next year.

The first key factor set to weigh on sterling was that euro-area investors were losing their appetite for U.K. assets, Nomura said.

"Foreign debt flows into the U.K. have been a major financing source of U.K. current account deficits, and euro area investors are major investors of U.K. debt securities," Nomura noted, adding that those investors became particularly aggressive after the European Central Bank (ECB) began a quantitative easing program which made British yields more attractive. But higher political risks in the euro area could put the kibosh on those flows, it noted."If euro area political risks increase further, higher volatility and wider peripheral spreads are likely, while sustained political uncertainty can hurt economic sentiment as well," it said. "As a result, foreign bond investment by euro area investors can slow, which will make U.K. external deficit financing more difficult," weighing on the sterling.

Bond yields have certainly shifted. In Europe's periphery, Portugal's 10 year bonds was yielding as much as 3.864 percent on Tuesday, compared with as little as 3.028 percent in October. Italy 10 year bonds was yielding as much as 2.228 percent in mid-November, compared with as little as 1.111 percent in September. Even German 10 year bonds  have become more attractive, with the 10-year yield rising to 0.397 percent in mid-November, from negative levels earlier this year. Political ructions at home have already taken a bite from the pound. That compares with the UK 10 year Gilts yielding 1.402 percent on Tuesday.

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