This time last week, the market seemed convinced that a UK-EU trade agreement would be done and dusted by now. Although negotiations had dragged on much longer than expected, positive comments from both sides implied that a deal was imminent. However, negotiations came to an abrupt halt on Thursday when the UK accused the EU of “moving the goal posts” at the last minute. Although talks resumed on Friday, discussions over the weekend did not result in any further progress despite the involvement of Boris Johnson and Ursula von der Leyen, the EU Commission President.

Unsurprisingly, sterling came under heavy pressure against all its major counterparts early yesterday morning, notably falling to $1.3225 and €1.0950. Boris made his position clear by reinserting the controversial UK Internal Markets Bill, but markets seemed to take comfort from the fact that talks remain ongoing, with the expectation that a deal would result in the contentious clauses being dropped.

This is now looking likely to be the case following a Tweet from Michael Gove (below), in which he announced that both parties had reached an “agreement in principle” on the implementation of the withdrawal agreement with regards to the protocol on the Irish border. Specifically, the agreement covers border control posts on animals, plants (and derived plant products), supply of medicines and various food products to supermarkets, alongside clarification on the application of State aid under the terms of the protocol.

Source: Twitter

Clearly there are key issues (believed to be surrounding Fishing Rights, State Aid and Governance) that still need to be overcome at committee level, but it’s another sign that things are moving in the right direction. Markets reacted accordingly with sterling to an intra-day high of $1.3393 and €1.1050, although clearly some nervousness remains (and rightly so, in our opinion).

To re-iterate a point we have made previously, we believe the FX market is under-pricing the risk of a “no deal” scenario for two key reasons: 1.Neither side seems likely to back down – Both Johnson and von der Leyen agree that “significant differences” remain on level playing field agreements and governance. 2.2. Time is fast running out – theoretically any ‘deal’ still needs to be ratified by both parliaments (although potentially a bridge could be put in place if a deal were to be agreed in principle by both sides).

Key Market Indicators: •Spot FX Rates – sterling remains relatively firm against the US dollar (although in part this is has been helped by a weaker dollar across the board). Arguably a more worthy indicator is the pound’s performance against the euro (GBPEUR currently resides at €1.10 having traded between €1.08 and €1.13 since mid-May). •Option Volatility / Risk Reversals – One-month volatility in GBPUSD and GBPEUR peaked at 12.03% and 10.41% respectively in September but have since fallen back to 10.14% and 8.83%. Although talks appear to be moving in the right direction, it’s surprising to see the market pricing in less risk today than it was three months ago. However, its worth noting that risk reversals (the cost of protecting against a move higher vs. protecting against a move lower) have become more negative, implying a greater risk to the downside for sterling.   •Positioning – Futures contracts continue to show a small net short position, although the extent of this has halved over the past month. To put the current positioning into context, net positioning was -107,000 contracts back in March 2017, a record low. In contrast, the latest data shows a net short position of just 7,899 contracts – the average since 2000, is -8,699 contracts. •Betting Markets – Betting platform Smarkets had the probability of a deal being agreed before year end at 85% on Friday. Yesterday, that dropped to 64.5% following talks over the weekend. Clearly a significant drop, 64.5% still intuitively feels very high.

One point that we can certainly take away is that risks for sterling are very asymmetric. If a deal can be reached, however slim, we see some marginal upside scope for the pound (GBPUSD up to 1.36 and GBPEUR up to 1.1250). However, in the event of no deal, downside risk appears far greater (towards 1.2500 for GBPUSD and 1.03 for GBPEUR).

In terms of a timeline from here, there was a suggestion that Michel Barnier, EU Chief Negotiator had tomorrow (Wednesday 9th December) pencilled in as a deadline for an agreement. However, today’s news from the joint committee buys more time for talks on a free trade agreement, making it slightly harder for either side to walk away this week. And so, it continues…

Author : Marc Cogliatti