- Another round of Brexit negotiations starts today, and volatility in the pound should follow
- While the pound rallied on domestic politics earlier this year, it's a headwind today
- The outcome from the last rounds of negotiations is unclear, with both sides far from compromise
With the Bank of England rate hike in the rear view mirror, the British pound is in search of a new narrative to drive future trading. In an earlier commentary, we wrote that economic data and central bank policy are now in the backseat as the Brexit deadline approaches. Looking at speculator sentiment, traders are no longer at extremes in the currency, meaning that the pound can go either way. This leaves politics, both domestic and international, as the key driver behind the currency. And in late 2017, British politics equals volatility.
Domestic politics not exactly ‘strong and stable’
Far from providing ‘strong and stable’ leadership, Theresa May’s government appears to be inherently weak and unstable. So far May’s government has been caught between a thin majority in Parliament, a string of scandals involving ministers in her cabinet, and leadership challenges from senior Conservative Party rivals.
The latest scandal to threaten May’s government involves former foreign aid minister Priti Patel. Patel, who resigned yesterday after holding unsanctioned meetings with senior Israeli politicians, initially avoided being terminated from her role. According to the BBC, she resigned after it emerged that she had met with Israeli public security minister Gilad Erdan. She has also been forced to correct an earlier claim that the Foreign Office was informed in advance of her trip. Patel’s resignation follows that of Sir Michael Fallon, the former Defence Secretary. Fallon has been accused of serious sexual abuses while in Parliament. In a recent resignation letter, Fallon wrote that his behavior had “fallen short” of the standards expected by the UK military.
While neither resignation is necessarily terminal for Theresa May, the continued instability of her government is negative for the pound. Earlier in the year, the currency was rallying after Theresa May had called elections in order to strengthen the Conservative Party’s position in Parliament. If the Conservatives had won an outright majority, the government would have had a much stronger hand when negotiating with the EU. Instead, May’s gambit backfired following poor national election results, and the Conservatives were forced to form a coalition government with the DUP. As May’s grasp on power continues to be weak, our view is that domestic politics is likely to remain a negative factor for the currency.
Brexit negotiations progress remain murky, with ‘Brexit bill’ talks ongoing
Looking at international politics, tangible progress from the ongoing Brexit negotiations remain unclear. The next round of negotiations is scheduled to begin today. As each round occurs every three weeks, there are only three rounds of Brexit negotiations remaining. As the two sides have yet to agree on EU citizen rights in post-Brexit UK and the size of the ‘Brexit bill’, the likelihood of trade talks being delayed is increasing. Given the importance of the service sector to the UK’s economy, the UK’s exit from the union without a trade deal would be greatly disruptive. As such, the pound would fall sharply in a no-deal (or ‘hard Brexit’) scenario.
Looking at the latest news, Michael Barnier, the EU’s chief negotiator, has repeated that the withdrawal agreement must be completed before trade talks can begin. According to Reuters, Barnier suggested that a trade deal with the UK would not be tailor made without significant delays. He pointed to the current deal signed with Canada as a possible template for a tailor made trade agreement. As the UK has already rejected ‘the Norwegian model’ (staying in the single market without any say, while accepting all membership costs), a deal based on the recent EU-Canada free trade agreement is more likely. As negotiations for such a deal would take at least two to three more years, he has further suggested a transition period following Brexit. This would allow the UK to remain in the single market, subject to all EU laws and costs, from March 30, 2019 (when Brexit goes into effect) until the end of the current EU budget in 2020. Such a transition period would minimize disruptions to trade.
As both sides appear far from compromise, the lack of progress relating to Brexit is also likely to weigh on the pound as March 2019 draws closer. Last month, Barnier stated that "We worked constructively. We clarified certain points. Without making massive steps forward". If this remains true following the next round of talks, the pound will remain weak as the specter of ‘hard Brexit’ comes closer to reality.