The leadership change in UK government has brought a change of Brexit direction. While the pound has adjusted to reflect an increased likelihood of a no-deal Brexit, volatility markets still discount a further extension of the deadline as their central scenario. The UK’s current account balance has also deteriorated, which could have a significant impact on the currency in the event of no deal.
Prime minister Boris Johnson has staked his premiership on delivering Brexit by 31 October. Everything he has done so far has reinforced the importance of leaving by that date, with or without a deal: the purging of cabinet; no-deal spending commitments; and the “do-or-die” pledge. His insistence that the backstop be removed prior to renegotiation does not augur well for a managed exit.
While the pound has adjusted to reflect this increased likelihood of a no-deal Brexit, we believe currency markets are still to factor in the impact of the UK’s deteriorating current account balance and its inability to attract funding to address the deficit should a no-deal Brexit occur on 31 October.
Mr Johnson’s hardball approach to renegotiation has not led to a change of stance from the EU, which views the backstop as the bare minimum of customs and regulatory alignment required to avoid the need for a hard border in Ireland, while protecting the integrity of the single market. Moreover, the terms of the previous extension preclude the reopening of the withdrawal agreement.
Thus, the likelihood of compromise is vanishingly small, and the chances of a negotiated exit at the end of October appear negligible. However, the current makeup of parliament is implacably opposed to a no-deal Brexit and will seek to stop it.
Legislating for an extension would be the most market friendly way of preventing no deal, but one that is contingent on an amenable speaker of the House of Commons. The nuclear option is a vote of no confidence; while the numbers look right for this to succeed, it would carry the risk of an election after 31 October in order to force through no deal – a move that would present a constitutional crisis and something that parliament would also try to prevent.
For the government, an election would be preferable to seeking an extension, and its messaging is consistent with preparing for this: the characterisation of the backstop as “undemocratic”; the shifting of blame for the inability to strike a deal to the EU and its refusal to drop its red line; and the enormous infrastructure and fiscal spending pledges. The most likely outcome, and one where most interests lie, is for an early general election.
With so many unknowns, constitutional wrangles and potential pitfalls, sterling is unlikely to perform well until there is greater clarification in the political landscape. In terms of what the market currently prices as the base case, Figure 1 shows the option-implied probability of GBP/USD (or dollar/sterling) at a given level on 1 November.
Figure 1: Market expectations for sterling against the dollar on 1 November 2019
Source: Columbia Threadneedle Investments/Bloomberg, 8 August 2019.
With the dollar index broadly unchanged between April and August this year, we can see that sterling-specific risk has risen. The chance of a no-deal Brexit (as defined by GBP/USD being below 1.14) has risen dramatically, albeit from exceptionally low levels, while the chance of Article 50 being revoked (as defined by GBP/USD being above 1.4) has collapsed. On balance, markets broadly expect the pound to be somewhat range-bound – namely, further political paralysis and an extension rather than revocation or no deal.1
The latest move of the current account balance to near all-time wides has been heavily distorted by companies stockpiling inventory ahead of the original March Brexit deadline. However, this should not mask the trend lower that can be observed since 2017, a move that runs counter to what should be expected given the weaker levels of sterling.2
Of more concern is the financing of this deficit: Q1 was the first time on record that foreign investors simultaneously withdrew capital from the UK across long-term direct investment as well as equity and debt portfolio flows.3 Given the need to attract such funding to help plug the current account deficit, and the implications of not doing so for sterling, we believe a move significantly below 1.1 cannot be ruled out – the inability to attract foreign financing in a no-deal scenario has not been priced in by markets.
1 Columbia Threadneedle Investments analysis, August 2019
2 ONS, Balance of payments, UK: January to March 2019, June 2019
3 ONS, Balance of payments, UK: January to March 2019, June 2019