Staring Boris Johnson, Michael Barnier, Jeremy Corbyn and a special presentation from Queen Elizabeth II.
Thursday last week, Boris Johnson and Leo Varadkar identified a “pathway” to a potential deal. Both leaders issued a joint communication saying that progress was made to identify potential for an agreement. Traders didn’t think twice about buying sterling. GBPUSD trading at 1.2220 with support evident around 1.2200 looked cheap on all valuation metrics as did GBPEUR. On this basis, there looks to be plenty of scope for further gains in the weeks ahead if a deal can be reached. Momentum drove the pound to a 3-month high against both the Dollar and the Euro at $1.27 and €1.15 respectively. The question is… with 17 days left to the Brexit deadline, is this a game changer? And what are the risks we should watch for in the short term?
Is this the game changer?
The short answer is no. Even if there is optimism and the word “progress” sparks hope for the UK to close a deal before the deadline on the 31st October, much still needs to happen for the spark to become the light at the end of the tunnel. Johnson’s plan proposes a complex solution where Northern Ireland leaves the customs union but sticks to its rules. The purpose of this approach is to be able to track the destination of goods entering Northern Ireland and treat them differently depending on where they end up. The DUP (Democratic Unionist Party) said that they won’t back up any deal that weakens Northern Ireland position with regards to its customs ties to the UK. The EU’s first assessment of Johnson’s plan was to flag the lack of detail and highlight that there is no empirical evidence that such a strategy might work, but instead it could leave the EU custom union open to the risk of fraud.
Johnson aims to gain DUP support today assuring Northern Ireland’s custom benefits with the UK and be able to present an accord for EU leaders to back up at the summit that starts on Thursday. With the accord endorsed, the next step would be to present the deal to parliament in a special session that would take place on Saturday (such session is still TBC) where we will find out if this is just another sea-son finale or Brexit’s grand finale. If Johnson is forced to delay Brexit then we should be prepared for another Brexit season full of uncertainty, drama and of course FX volatility.
The next 48 hours are crucial. Today’s Queen speech presents the plans of the government as part of the State Opening of Parliament ceremony, which marks the start of the parliamentary year. After the inauguration speech, MPs will debate its contents and the Prime Minister will “sell” the Brexit plan to the House of Commons. This debate is known as the “Humble Address” and it takes around 5 days ending with a vote, which historically has been symbolic, but this time parliament are effectively saying if they support or reject the government’s plan.
Let’s remember that Johnson has lost seven consecutive House of Commons votes and it’s no secret that he doesn’t have the numbers to win the vote as things currently stand. Jeremy Corbyn will stick to his guns in opposition making life very difficult for the Prime Minister.
Key takeaways from the rally
The latest Sterling swing confirms that anything can happen, and the market is ready to react to any fundamental changes. We can learn from patterns and behaviour. In the case of a deal being agreed, we see a strong rally of Sterling above Friday’s high. As long as a deal is under negotiation, as is now, we expect sterling to be stuck in a range, but if we see an extension being granted, then such range is subject to increase and so is volatility. A no deal Brexit shall trigger a sell-off for the Pound against all its major counter-parts below the lowest of this year. Let’s remember that many research teams are pricing parity between GBP and EUR in the event of a hard Brexit.
From our perspective, if fundamentals remain un-changed, we expect volatility to remain high taking a bearish view in the days to come. Current levels and technical analysis suggest risk of a retracement of the recent rally 1.2700. We are expecting Boris Johnson to stick to his track record of parliamentary losses and the most likely scenario is an extension of the dead-line. Mr Juncker already suggested such request would be honoured by the member states. If we find ourselves in an extension scenario focused on moving forward with current negotiations, a wider range of volatility will be induced with scope for further gains in the near term.
Fundamental drivers can seem drastically bearish for Sterling, but the long term looks promising for those with the virtue of patience. Even after the strong rally of last week, PPP valuations still conclude that Sterling is undervalued, (-13% vs the Dollar) while 3% from it’s fair value against the Euro. One the biggest drivers of a bearish outlook is the fact that nobody knows what a hard Brexit means for the UK going forward… but this uncertainty will gradually clear after the market understands the repercussions and capital flows will adjust in the long term.