Morning Commentary: Conflation

Foreign Exchange - Morning Commentary
Conflation
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
The British pound had been on an absolute tear leading up to last week’s election on hopes that a large Conservative majority would finally be able to pass a Withdrawal Agreement.  As it turns out, the opinion polls were correct in predicting a win for the Conservatives as they won their largest victory in many decades and the GBP staged a sharp rally.    

However, heading into this week, the pound’s price action gave us some concerns that the markets were conflating the removal of political risk with the repair of economic damage.  Even if the UK Parliament was able to pass a Withdrawal Agreement (WA) in January, it still needs to pass a free trade agreement in less than a year, which is a herculean task.  Should the two sides fail to reach an agreement and fail to extend the transition period, the UK/EU trading relationship would revert to WTO rules and the markets would, in essence, have a hard Brexit despite the passage of a WA. 

Overnight, the post-election honeymoon appears to have ended and markets have been reminded of this cold reality.  By announcing that he will change the law to ensure that the Brexit transition phase is not extended, PM Johnson has reintroduced the risks of a hard Brexit and pushed the GBP back down to pre-election levels.   

To be sure, this is a negative development for the markets, but it is also likely that this is a negotiating tactic.  A simple glance at Brexit history shows similar episodes where the UK “committed” to leave the EU by a hard deadline only for that not to happen. 

While all trade deals are difficult to negotiate, the UK-EU relationship is especially tricky as it attempts to ensure a close degree of economic integration but not grant all the benefits of EU membership.  As such, setting a goal of achieving a trade deal in less than a year is very ambitious.  For context, it took the EU five years to reach trade deals with Japan and Canada and two decades to get a deal with the Mercosur group of Argentina, Brazil, Paraguay and Uruguay. 

Should the UK be serious about its pledge to not extend the transition period, expect any deal to be relatively shallow, narrow, and exclude anything of substance on services or internal security. Given this, we still expect the UK to ultimately seek an extension to the transition period.  However, this will likely come at the last minute to ensure some credibility to the Conservative’s campaign promise.  Either way, expect GBP volatility and headline risks to continue despite an election result that, in theory, removed some risks from the market.
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
  • The RBA released its December board meeting minutes last night.  The minutes continue to show that the board wants to continue to wait and assess how prior monetary action is affecting the economy.  Notably, the minutes stated that members “agreed it would be important to reassess the economic outlook in February 2020,” suggesting that the board is keeping the door open to a February cut.     
  • In an effort to meet its pledge to increase purchases from the US, it has been reported that China plans to restart purchases of ethanol by lifting or waiving trade war tariffs on the fuel. Additionally, China could re-route trade that currently passes through Hong Kong to mainland ports. 
  • US industrial production came at 1.1% MoM, beating estimates for a 0.9% gain as well as reversing two months of consecutive declines.
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