GBP: Barnier’s Brexit Boost

We believe the politics will continue to outweigh the economics for GBP in the short-term – especially if the Brexit strategy of UK government remains one that is seemingly trying to fit a square peg in a round hole. Only a concrete resolution between UK and EU officials over the Irish backstop dispute – which would effectively finalise the Withdrawal Agreement and significantly reduce the odds of ‘No Deal’ Brexit – would trigger a material move higher in GBP over the coming months.

There are two probabilities for GBP investors to consider: (1) the perceived odds of a no-deal and (2) the actual odds of a sudden regime shift in the UK-EU trading relationship:

1. The perceived odds of a no-deal Brexit have materially increased – and this is likely to keep GBP under pressure in the near-term as politicians take Brexit towards the brink of a cliff-edge. There are signs that GBP markets are already pricing in a large degree of political uncertainty (GBP’s reduced sensitivity to macro data surprises and relative interest rates; a pick-up in short GBP positioning; the breakdown in high-frequency correlation between EUR/USD and GBP/USD).
2. But we still feel the actual odds of a cliff-edge Brexit are significantly lower – with economic logic to triumph over political ideology in the end. The odds of a sudden economic regime shift – and a sudden switch to WTO trading rules between the UK and EU is a highly improbable scenario in our view. We still believe that this outcome will be avoided at all costs by politicians – and if this is the case, then we do not subscribe to the idea of another sharp Brexit-related GBP depreciation over the coming months (not least given that we’re already at weak levels).

While we are short-term GBP bears, we remain constructive on the medium-term prospects for GBP – given our house-view that a politically acceptable withdrawal deal will be struck between the UK and EU.

Based on the BOE’s latest r* estimates, we note that the term structure of UK interest rates is around 75-100 basis points too low right now. Long-term UK interest rate expectations will remain distorted by Brexit no-deal risks in the immediate future – and any sustained shift higher in the UK curve won’t transpire until some of these Brexit tail risks have been concretely taken off the table. Indeed, throw into the mix the unique Brexit uncertainties surrounding the UK economy – and this renders r* an almost redundant factor for UK rate markets right now. Indeed, when we think about the conceptual factors that drive r* – demographics, productivity, fiscal policy, savings-investment imbalances, demand for safe assets – one could argue that these would look inherently different in a ‘soft’ versus ‘hard’ Brexit world.

We’ll also need to see actual signs of a UK economic recovery – and positive UK data surprises over coming months could also lift short-term domestic rates and the pound. Our medium-term bullish GBP view – which sees GBP/USD at 1.40 (EUR/GBP 0.85) at the turn of the year – is partly based on this structural re-pricing UK interest rates driven by a fading Brexit risk premium.