Reality bites sterling as EU remain firm on state aid and and withdrawal agreement

The pound has been hammered this morning by the twin revelations that trade talks have failed to produce a breakthrough on the crucial issue of state aid, and that the EU has prepared a legal response to the Government’s Internal Markets Bill. After several weeks of rallying based on vague statements from negotiators about being “hopeful” and a deal being “possible”, sterling is now facing up to the harsh reality of an uncompromising EU stance on state aid and last year’s withdrawal agreement.

In percentage terms today’s sterling losses are noteworthy, but we have seen several equally large or larger daily falls in recent months. The question now is what Boris Johnson will do when faced with the EU’s red lines – the same ones that ultimately doomed his predecessor’s efforts to reach a deal.

Ostensibly, the Government has been as firm as the EU in insisting the internal markets legislation will remain unchanged. State aid seems a strange hill for a Conservative Government to defend at all costs, but that has also been a fairly consistent position from ministers. However, the recent trade deal with Japan shows that Boris Johnson is willing to accept some binding commitments in this area.

Clearly, there is room for a deal to be done, if Johnson is willing to spend the political capital necessary to budge on these two areas.

It’s probably this residual possibility of a deal that’s preventing a more severe sterling sell-off, as market participants have seen many an 11th-hour deal struck over the Brexit saga. In the worst-case scenario of a complete end to talks and a formal move towards no-deal at the end of this year, we believe there will be further significant downside for the pound, in the order of a 5-8% drop from today’s levels.

GBP down against USD and EUR

But in percentage terms the move is comparable to other recent sell-offs

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