Season 1 of ‘Solving Brexit’ ends on a high… as divorce deal is agreed
In what is quickly turning into a reality TV show, the latest episode of ‘Solving Brexit’ has ended on a high for GBP, as a last-minute deal between Theresa May and the DUP on the Irish Border has enabled initial Brexit divorce proceedings to be wrapped up. In a joint statement with PM May in Brussels, the EU’s Jean-Claude Juncker said that ‘sufficient progress’ has now been made – such that Brexit talks can move onto discussions over a future trade deal.
While the divorce details will still need to be ratified by respective domestic politicians (EU leaders and the UK government), it looks as though this is now just a formality. While agreeing a ‘divorce bill’ has little economic significance for the price of GBP, the political significance of progress in Brexit talks is quite profound – not least as it reduces the tail risk of a 'no deal' scenario and a complete breakdown in negotiations.
Our game theory application to Brexit negotiations is proving a handy framework for analysing the political risks to GBP. While much of 2017 has been marred by UK and EU politicians playing ‘hardball’ with one another, the resolution of a Brexit divorce deal suggests the tide may be turning in a constructive direction. Politicians moving away from seeking to protect their own domestic interest (the Prisoner's Dilemma scenario) – and slowly moving towards a mutual agreement – is unambiguously positive for GBP.
GBP is broadly higher on the news, although we may see some profit-taking as a reassessment of the Brexit political games looks to already be priced in. While the hard part (trade talks) is still to come – and a realisation of this may keep GBP/USD capped at 1.3550/1.3600 in the near-term (EUR/GBP around 0.8650/0.8700) – we do ultimately believe that there is more upside left in GBP over the next 3 months.
We look for GBP/USD to move up to 1.40 were a Brexit transition deal to be agreed in early 1Q18
Brexit transition deal is a weak GBP’s antidote
We believe that GBP markets are underestimating the cyclical economic benefits of a Brexit transition deal. Judging by GBP's rally since early November, a reassessment of the Brexit political games looks to already be underway.
But we feel there is more upside to come – especially if a transition deal were to be signed, sealed and delivered in 1Q18. Our ‘GBP Brexit Equation’ (below) demonstrates the chain of logic here. With a range of indicators suggesting that the UK economy is at a standstill, a reduction in medium-term uncertainty may rekindle some of the ‘animal spirits’ among consumers and firms – and see more cash put back to work over the coming year. At a time when the BoE is in tightening mode, positive revisions to the UK growth outlook – and a subsequently steeper rate curve – could be a powerful pick-me-up for a weak pound.