The outline of the key Brexit scenarios, and how sterling is likely to trade in them, is once again becoming clearer.
Boris Johnson finally presented the outline of his plan for a withdrawal agreement. The key question for the immediate future is if talks with the EU result in a withdrawal agreement that the Government is willing to present to parliament.
There are a plethora of reasons to believe talks will end in failure. The initial response to Boris Johnson’s proposals last week was negative but didn’t represent outright rejection.
The European Parliament’s steering group said that the proposal was not “a basis for an agreement to which the European Parliament could give consent”, while Irish leaders were even clearer in their opposition.
Despite this, a deal is at least possible. The fact that Boris – and the DUP – were willing to concede partial regulatory alignment with the EU for Northern Ireland indicates that there is at least a slim chance of a breakthrough, perhaps in relation to a time limited backstop, or modifications to the “Stormont lock”.
In the more likely scenario of a breakdown in talks, the key question will be if the Government intends to comply with the legislative intention of the Benn Act and seek an extension to the October 31st deadline.
Cabinet ministers as well as Johnson himself have repeated that the Government’s intention is to leave the EU on October 31st, despite the Benn act, without stipulating exactly how the legislations provisions could be sidestepped or defied outright.
A legal test of the act, circumvention using national emergency legislation, another prorogation of Parliament, or even outright non-compliance are all possible options.
A few thoughts on sterling’s possible reaction to these scenarios:
- Our estimate is that market pricing of No-deal currently sits around 20-30%, down from as high as 50% prior to the passage of the Benn act. This marginal reduction in no-deal risk was associated with a rally of approximately 3% in sterling against the euro and US dollar.
- A collapse in negotiations is likely to raise the perceived chance of no deal significantly, but in our view not to the point where it is a base case for the market. Losses in the order of 2-4% for sterling would be likely, taking GBPUSD and GBPEUR to around or slightly below their lows in early September. A breakthrough in negotiations would, conversely, see a relief rally of at least up to the 1.28 area for GBPUSD.
- Should an extension be granted by October 31st, a modicum of a “relief rally” might be seen in sterling. Given that at this point the Conservative Party would be openly campaigning on a no-deal platform, the outcome of the election would be highly uncertain and a relief rally for sterling would likely be short lived.
- In a full no-deal scenario, our view remains that GBPUSD would trade in around the 1.10-1.15 area.
OIS Implied probability of a rate cut
The implied probability of a rate cut in November according to Overnight Index Swaps can be viewed as a proxy for no-deal risk.
Copyright: Bloomberg Finance LP.
This is not a perfect proxy – but we note that as of Friday 04/10, Oddscheckers odds of a no-deal Brexit in 2019 were quoted at 4/1.
This is broadly consistent with the OIS implied pricing and informs our subjective judgement that the market is pricing a 20-30% no-deal risk now.
Author: Ranko Berich, Head of Market Analysis at Monex Europe