Brexit Weakens Rate Hike Support for Sterling

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Brexit continues to hound sterling.  The risk of no agreement appears to be increasing, and the UK may very well head toward a political crisis over what was initially a non-binding referendum.  We explore the implications here.

There are three main influence for sterling.  The first is the general dollar direction.  As widely recognized, the greenback was weak last year and this has continued into this year’s activity.  After falling in January, the dollar is set to close higher against all the major currencies but the Japanese yen.  Sterling’s 2.6% decline (~$1.3820) this month cuts last month’s gain in half.

The second driver for sterling has been the prospect for another rate hike after last November’s move.   Sterling began the week on a firm footing, reaching $1.4070, on the back of hawkish comments by BOE Deputy Governor Ramsden who changed tone from his dissent from the November rate hike.  This coupled with recent comments from Carney fanned speculation of a May rate hike.

The Bank of England meets next week, but interpolating from the OIS market suggests about a one-in-seven chance of a hike then, up from about a one-in-25 at the start of the month.  A little more than a 50% chance of a hike is discounted for May.  It finished last year near 31% and was a little below 40% at the end of last month.

The third driver is Brexit.  From the outside, it appears the UK has a sweetheart deal.  It is part of the EU, but is has opt out privileges from the area’s boldest initiatives including the common currency and the Schengen Treaty.   Its strategy of seeking a broader rather than a deeper union has been quite successful.  However, as the EU grew over the past several decades, the principle of unanimity in decision-making had to give way to more qualified majority voting.  This led to the UK losing its veto on numerous issues (but not all).

Many in the UK argue it was the EU that changed.  There seems to be some truth in that claim, but efforts to increase the range of cooperation and deepen the union has been a consistent current, though one that the UK found easier to resist in the past.  Moreover, it is also true that a part of the Tories and UK voters have been consistently opposed to the EU.

Once the UK formally declared it was going to leave, the EU held all the cards. They determined the structure of the negotiations.  First the divorce settlement, then the new relationship.  At the UK’s insistence a third step was inserted, a transition period.  From the EU negotiators vantage point, the UK has been in denial and when they emerge from denial they want to pick the parts of the EU that benefit them, like the single market, and abandon what they do not want.  This is seen as cherry-picking, or of having one’s cake and eating it too.

That is what has happened today.  EU officials have released their draft of the Brexit treaty, and Prime Minister May rejected it immediately.  Sterling sold off nearly a cent against the dollar and the euro rose from GBP0.8780 to almost GBP0.8850.   The Irish border issue, which prolonged the first phase of negotiations, has not been completely addressed by the UK, and the EU’s draft calls for Northern Ireland to remain in the EU’s customs union after Brexit.

This is not acceptable to the UK government.  After losing her parliamentary majority last year, May has relied on the Democrat Unionists from Northern Ireland.  Peace om the island was made possible by both parts being in the EU.  This makes unnecessary hard border controls.  The UK’s decision to leave the EU puts this agreement at risk.  May’s reliance on the DU also limits her ability to negotiate. There are other outstanding issues, like the application of EU laws and the role of the European Court of Justice during the transition phase.

May’s position has always been difficult and it is getting more untenable.  Her party is badly split.  Labour has risen in the polls, and Corbyn has come out in support of continuing the customs union, which is also supported by the CBI.  Efforts for a second referendum at some point seem to be gaining ground.  Recall that the 2016 referendum was a non-binding referendum.  There is also a risk that the UK leaves without a deal, and this seems to be the weight on sterling.

The UK seems to be headed toward a political crisis. It could come as early as next quarter. Losses in the local elections in May could spur a leadership challenge.  It could also lead to a third election in as many years, even if that is not the most likely scenario.

Sterling is testing the $1.3800.  The low from earlier this month is near $1.3765.  A trend line drawn off the mid-November low (~$1.3060) and the low from Boxing Day (~$1.3350) is found now near $1.3740.  The $1.3700 area represents a 50% retracement of the gains that the trend line captures.  A break could see a return to the $1.3550 area.

The euro has been in a clear range against sterling over for nearly three months.  The lower end of the range is around GBP0.8700 and it has not been seen this month.  The upper end of the range is near GBP0.8900 and its was probed near the middle of the month before easing to GBP0.8770 to start the week.   Presently, the technical indicators suggest sterling is more vulnerable against the dollar than the euro.