Morning Commentary: Brexit: What is the Upside Potential?

Foreign Exchange - Morning Commentary
Brexit: What is the Upside Potential? 
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Volatility around the British pound (GBP) exchange rate was always expected to increase as we moved closer to the end of the negotiating period. But even by this standard, the ping-pong headlines and multiple intraday swings over recent trading sessions has been striking. As we approach the EU council meeting on Oct. 15, expect elevated volatility in the exchange rate to persist as markets attempt to benchmark the prospects of a deal. It should be noted that Oct. 15 isn’t an official hard deadline, but the U.K. has indicated that it would quit Brexit talks if a clear landing zone for a deal hasn’t been identified by that date. In response, the EU has called the U.K.’s bluff by saying Brexit discussions at the EU summit will likely be a “stock-taking exercise,” indicating that a near-term breakthrough is unlikely.

Ultimately, it is difficult to ascertain how much progress has been made during Brexit negotiations, but markets are encouraged by recent communication between U.K. Prime Minister Boris Johnson and EU Commission President Ursula von der Leyen. Despite this, the outlook for the GBP remains asymmetrically skewed to the downside due to the consequences of a narrow deal or no deal. Put another way, there is more room for GBP downside on a no deal than there is for GBP upside on a narrow trade deal.

There are three arguments supporting this. The first is the risk premium, or lack thereof, priced into the GBP. Currently, the pound sits ~6% above its post-referendum low, which likely marked peak pessimism. Even if you take a positive view on Brexit, it is hard to argue that the GBP should appreciate materially above its average over the five years leading up to the referendum. If this is the case, then the ceiling on a relief rally is closer than the floor on a no-deal exit.

The second argument stems from the negotiation period only marking the start of economic consequences. A debate can be had over the ultimate impact of Brexit, but there is little debate around the fact that Brexit has already extracted an economic cost. This cost has further cemented the U.K.’s transition from a high-growth country to a below-average-growth one. At a minimum, this downshift in the U.K.’s growth rate makes any comparison to the GBP’s higher long-term averages a misleading guide to the GBP’s rebound potential post-Brexit.

Finally, there is the pent-up foreign demand argument. It has been argued that foreign investors have been sidelined since the referendum and will return once Brexit is in the past, driving the pound higher. However, balance-of-payment data shows that foreign inflows to growth-sensitive assets have continued at roughly the same pace as before the referendum. In a way, this is GBP positive. While there isn’t pent-up demand, there also hasn’t been any apparent loss of confidence. Nevertheless, risks remain for a belated repatriation of foreign investments from the U.K. under a no-deal outcome. With gross foreign liabilities more than four times GDP, the pound’s exchange rate remains susceptible to foreign investor sentiment.
  • U.S. initial jobless claims disappointed, as they came in at 840,000 versus expectations for 820,000 claims. Last week’s number was also revised up to 849,000 from 837,000. Overall, these numbers support the current narrative of a labor market under pressure and a slowdown in economic momentum after reopening.
  • The vice presidential debate, relative to the first presidential debate, was a much more substantive discussion of policy. China and the current administration’s trade war was a key topic of the debate. The view remains that a Biden administration would take a more multilateral approach against China that would rely less on tariffs and focus more on human rights. In essence, a Biden administration would approach U.S.-China relations differently, but that doesn’t mean it would be less hawkish.
  • Polling continues to show swing states moving in favor of Biden. Notably, Biden is competitive in typically red states, such as Arizona, Ohio, North Carolina and Georgia, that Trump won by significant margins in 2016. The USD remains under pressure, as this polling data supports the view of a Democratic sweep that could lead to massive fiscal stimulus in 2021.
  • Whether or not the next presidential debate will be held remains up in the air. The commission responsible for staging the debate has announced that it will be held remotely. However, President Trump has declined to debate remotely and indicated he will hold a rally instead.
  • Stimulus talks are gaining some momentum after headlines indicate Democratic willingness for stand-alone airline aid. Conversely, there remains disagreement over the $1,200 individual stimulus checks. House Speaker Pelosi views these checks as inadequate without a larger package of measures. Speaker Pelosi and Treasury Secretary Mnuchin will speak again today.
  • According to minutes from the ECB’s September meeting, central bank officials believed third-quarter growth would be better than previously expected, but inflation concerns remain.
  • COVID-19 infection rates continue to rise in Europe, with France and Germany announcing new restrictions.
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