Following on from yesterday’s humiliating dodge, May now goes to Brussel’s to discuss going forward with Jean-Claude Juncker. Little has changed to our base case, despite the formal rejection of her draft Withdrawal Treaty not taking place.
The $1.25 level has been realised, and May now goes to Brussel’s in an attempt to fudge contentious issues to force marginal voters to stand behind the government when the deal is finally put to a vote sometime next year.
The EU has already rejected the idea of the deal being re-opened for renegotiation, but are willing to give greater clarity and interpretation to the grey lines – one of which is the backstop mechanism. This may prove sufficient if greater clarity on the UK withdrawal to the backstop mechanism is given.
May could indeed gain further concessions and run the clock down in the meantime, and by doing so increasing the consequences of her deal not being accepted, but any minor tweaks to the Treaty are unlikely to be legally binding. It is our belief that this won’t be realised prior to the New Year, and May will give the Commons another chance to stop a no-deal Brexit scenario occurring sometime in January.
Regardless, both sterling and sterling option pricing remain highly sensitive to the increasing uncertainty facing them. With the March deadline rapidly approaching, the cost of 3-month protection against sterling weakness is edging towards referendum levels, while the cost of 1-week protection is also rising. The implied volatility curve has inverted for the pound with both short-term and 3-month options continuing to consolidate gains.
What does this mean for sterling?
The $1.2515 level may continue to be tested but below which there remains little to prop sterling up from a technical standpoint until $1.23. Therefore, the $1.25-26 handle may become the new $1.27 level where sterling previously gripped on to prior to yesterday’s news. Regardless, the macroeconomic data is redundant for now, and the pounds price action will be dependent on rumblings from the continent. Meanwhile, one cannot rule out the repeated calls from Parliament for May’s head and a second referendum, but this remains a tail risk in our view.
Risks to this outlook remain, however. May could still not find enough support in Parliament and the deal is off the table prior to March. This will bring a myriad of problems if it is the case, as May would most probably have to step down as Prime Minister. This opens the door for a new government and greater uncertainty will be added to the Brexit process. Furthermore, the Tory party could become increasingly disgruntled and force May out as her current middle of the road stance isn’t suiting either side of the factious party. The possibility of May not being the British PM in March remains highly probable, but not as probable as our base case due to the appetite from both the EU and Parliament to have a deal in place by March.
Chart 1: Sterling holds strong at $1.25 for now, but has room to fall further if pressure on May and uncertainty over Brexit ramps up
Chart 2: For this reason, the premium on sterling downside protection over the next 3-months edges further towards referendum levels