Report8 December 2017Updated one year ago

GBP: Brexit Breakthrough

It looks like GBP is breathing a sigh of relief as Season 1 of ‘Solving Brexit’ comes to an end. But be sure to tune in again in January as the narrative turns to transition and trade

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.

Source: ING, Bloomberg

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.