investment insights
A Q&A on Brexit developments and GBP implications
There have been plenty of developments on the Brexit front this past month, though substantive progress was limited. With so many twists and turns in the Brexit drama, we think it is useful to present a Q&A on what has happened and elaborate on the implications for sterling.
What was the outcome of the UK parliament vote on the Withdrawal Agreement (WA)?
The WA between the UK and the EU, which was endorsed by the two sides in late November 2018, was finally brought for a vote to the UK parliament on 15 January. It was rejected, as expected, by a surprisingly wide margin of 230 Members of Parliament – 202 in favor and 432 against. It was the biggest defeat inflicted on any government in modern history, which prompted Labour party leader Jeremy Corbyn to call for a vote of no confidence in the government.
Vote of no confidence in the government
The motion took place on 16 January and it was rejected as the Democratic Union Party (DUP) – which has supported the Conservative minority government since the general elections of 2017 – stood by the May administration.
Prime Minister May’s determination to continue with the negotiations gave the market a positive signal: in particular, her statement to seek cross-party discussions on how to proceed with potential adjustments to the WA opens the way for a broader support to a “modified deal”, offsetting the dissent of hard Brexiteers.
How did sterling react to these developments and why?
Despite the rejection of the WA, GBP has rallied since Tuesday evening, rising towards 1.29 and EURGBP dropped below 0.89. We think two developments have contributed to market optimism. First, the defeat of the no confidence motion has substantially reduced the probability of a general election and its associated uncertainty (e.g. the low probability of a Corbyn-led government, which would be perceived as business-unfriendly). Second, and most importantly, Prime Minister May’s determination to continue with the negotiations gave the market a positive signal: in particular, her statement to seek cross-party discussions on how to proceed with potential adjustments to the WA opens the way for a broader support to a “modified deal”, offsetting the dissent of hard Brexiteers.
How will things move forward?
An extension of the Article 50 deadline (currently 29 March) is highly likely as time is very limited. PM May will consult with party leaders in order to draft a set of proposals for changes to the WA to be communicated to the EU (Jeremy Corbyn has refused to participate in the discussions so far, unless PM May “removes the prospect of a no-deal Brexit”, which certainly complicates the situation further). Currently, it looks unlikely that the EU will agree to grant the UK the right for a unilateral exit from the Irish border backstop. Offering to strengthen the political declaration to reach a trade deal with the UK during the transition period is highly probable. Whether more meaningful changes to the WA would be accepted by the EU remains to be seen (and this is very hard to achieve). In our view, the aim now is to agree a set of modifications to increase the chances that in a subsequent round of voting (maybe the next few weeks) the modified WA gets broader parliamentary support.
we reiterate our view that the medium-term outlook for GBP is bullish: we expect a gradual pricing-out of the hard Brexit premium as well as some repricing higher on the BoE rate trajectory (subject to a soft Brexit).
What does this mean for sterling?
No doubt, the situation remains highly complex and fluid. But May’s decision not to resign – after such a resounding defeat – and her determination to proceed with the negotiations offered some comfort to the markets. It has been interpreted as further reducing the probability of a disorderly Brexit and increasing the likelihood that – after intense debate and some changes to the WA – there will eventually be a UK parliamentary compromise leading to a soft Brexit.
In line with this assessment we reiterate our view that the medium-term outlook for GBP is bullish: we expect a gradual pricing-out of the hard Brexit premium as well as some repricing higher on the BoE rate trajectory (subject to a soft Brexit).
However, near-term the currency will remain subject to political headline risk and vulnerable to sell-offs each time it rallies – we expect gyrations between 1.26 and 1.30.
The likely extension of the Article 50 deadline is fundamentally positive for sterling but it does suggest that we will go through a longer-than-initially-expected period of negotiations and uncertainty. Hence, we have cut our 1Q19 forecast for GBPUSD to 1.32 from 1.35, and our 2Q19 forecast to 1.35 from 1.37. Our year-end target remains unchanged at 1.37 under our central scenario of an eventual soft Brexit deal.
In the (very unlikely) scenario of a no-deal Brexit, we would expect GBPUSD to trade towards 1.15 as the market would price-in a near-collapse of the UK economy. EURGBP would trade towards parity.
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
Read more.
share.