What are the markets telling us about Brexit?

As we enter March, it is just four weeks until the UK is due to leave the European Union. Recent months have been full of uncertainty about the terms for Britain’s departure with many fearful of what a hard Brexit could mean for the UK economy. Sterling came under heavy pressure throughout the latter stages of 2018 while UK interest rates tumbled as markets scaled back expectations of the Bank of England tightening policy in 2019.


However, expectations for Brexit clearly shifted during the second half of February resulting in a 4% rally in GBPUSD and a 3.2% advance in GBPEUR. Meanwhile the 2-year sterling swap rate has risen 8 basis points to 1.11%.


What has changed?


Simply put, markets appear to be ruling out the prospect of a No Deal / Hard Brexit. According the bookies, the probability of No Deal has fallen from 25% to 12%. Meanwhile, Goldman Sachs have cut the probability they assign to No Deal from 15% to 10%. That ties in with what we’re led to believe from the majority of politicians who agree that a hard Brexit should be avoided at all costs.


Unsurprisingly, Theresa May has been reluctant to take No Deal completely off the table. If she were to do so, she would remove any bargaining power she currently has with the EU and there would be no incentive for Barnier and Co. to concede anything in the negotiations over the Irish backstop.



 What happens next?


Theresa May has set out a three-point plan for Parliament to address next week. If the PM’s revised deal does not garner enough support, MPs will vote on a no deal Brexit. If that is rejected, MPs will vote on an extension to Article 50. This outcome is heavily favoured by the betting markets which are pricing an 82% probability of an extension and is supported by a fall in FX option volatility (GBPUSD 2-month implied volatility has fallen from 12% two weeks ago to 9.8% currently).


What are the risks?


As risk managers, we’ve learnt to expect the unexpected. Thinking back to the referendum in 2016, sterling rallied from $1.41 to $1.50 in the days before the vote in anticipation that the British public would vote to remain in the EU. We’re not saying that we expect the UK to leave the EU on 29th March with no deal, but if such an event were to occur, the downside risk to sterling, given the rally over the past couple of weeks are now significantly greater. For the record, we still see $1.10 – $1.15 as a target range if Britain were to leave without a deal.


Meanwhile, we continue to see some upside potential for sterling if Theresa May can get her deal through the Commons. Our target is still $1.35 although we note there are a number of forecasters suggesting further upside potential for sterling. The chart below shows the latest forecasts from the Bloomberg FX poll.


Chart 1 – Bloomberg FX Poll – GBPUSD

Source: Bloomberg


Although the range of forecasts in the chart above is interesting, the most notable take-away is that the median (1.36) is considerably higher than current spot (1.32). Normally, we’d expect the median to be much more in line with current spot (suggesting 50% of people see the market going up and 50% see it going down). 


Interestingly, this optimism isn’t supported by the latest CFTC data which still shows a net short position on sterling futures, although its worth noting that this has halved since September. This supports the notion that there is plenty of scope for a rally in the event of a GBP positive outcome.


What should we look out for in the months ahead?


The next major focal point on the calendar is 12th March when MPs get to vote on Theresa May’s renegotiated deal with the EU. Although European officials are reported to have softened their stance slightly and UK MPs are slowly coming around to May’s deal, it still seems unlikely that the PM will win a majority vote. With MPs certain to vote against No Deal, Article 50 looks set to be extended beyond the end of March. This approach is also supported by Michel Barnier who sees a delay as “inevitable.”


As markets price in an increased probability of a soft Brexit, sterling is likely to become more sensitive to more traditional market influences (e.g. interest rate expectations). This morning’s UK construction PMI figures were a prime example of this… in recent months, the data would have been overlooked in favour of Brexit developments, but a weaker than expected number, that fell below the all important ‘50’ level that shows the sector contracting, put sterling under pressure. Going forward, we expect the market to pay more attention to economic data given that the Bank of England is likely to be more data driven if the threat of a hard Brexit is eliminated.


Author: Marc Cogliatti



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