BNY Mellon: Brexit Update - What's Priced In?

26 november 2018

By Simon Derrick, Chief Currency Strategist, BNY Mellon

With plenty happening over the past week or so, it's worth rounding up the main developments along with the market's reaction to them.

Today

Declaration on EU/US ties post Brexit

EU President Donald Tusk tweets :“EU27 has endorsed the Withdrawal Agreement and Political Declaration on the future EU-UK relations.”

European Commission President Jean-Claude Juncker says: ”This is the best deal for the UK, the best deal for Europe, this is the only deal possible.” Speaking directly to UK MPs he asks then to "take this into consideration”

UK domestic politics

Prime Minister Theresa May tweets a letter urging UK citizens to "come together again as one people”.

PM May tells the media: ”There should not be that second referendum. The public would expect parliament to vote on the deal. For most people in the UK they want a deal done and want us to get on with focusing more clearly on the issues that matter to them day to day.”

Shadow Secretary of State for Brexit Kier Starmer tweets: “This is a bad deal for our country. It’s a failure of negotiation by a Prime Minister who has spent more time arguing with her party than working in the national interest. The result is a deal that no-one supports. Labour will vote against it.”

Arlene Foster, leader of the DUP, reiterates to the BBC that there are no circumstances under which she would back the deal. She adds that she does not believe the deal will make it through Parliament but notes that the DUP will have to wait and see what happens next before they decide to if they will remove their support from the government.

The past week

Monetary policy

Speaking on Tuesday in front of the UK’s Treasury Select Committee, BOE officials all stressed that a failure to agree a deal would not lead to the bank lowering interest rates.

A second vote?

The FT has highlighted that speculation is growing that, if the government loses (the Commons vote on the Brexit deal), it will mount a second attempt to get the pact approved by MPs. The paper noted that “some MPs and commentators believe that, if she is defeated, there will be a significant financial market reaction that concentrates minds. MPs refer to the way that the US’s Tarp scheme to bail out banks after the 2008 crash was initially rejected by Congress, causing the stock market to collapse. Congress then panicked and voted through a modified version of the scheme.”

A general election?

Speaking at a Reuters event on Wednesday the Shadow chancellor, John McDonnel, said that since Conservative MPs were unlikely to vote for an election they might lose, they would be reluctant to short-circuit the Fixed-term Parliaments Act, which sets down a date for the next election on May 5 2022. He noted: “At the moment that’s difficult to see.”

A second referendum?

At the same event, Mr McDonnel refused to say whether remaining in the EU would be a choice in any second referendum under a Labour government, simply noting there would be “a range of options” for consideration on a ballot paper.

When asked about a second referendum on Sky just over a week ago, Labour leader Jeremy Corbyn said: “It’s an option for the future, but it’s not an option for today. If there was a referendum tomorrow, what’s it going to be on, what’s the question going to be?” He also noted: “There was a referendum in 2016, a majority voted to leave the EU, there are many reasons why people voted. I don’t think you call a referendum and then say you don’t like the result and go away from it. You’ve got to understand why people voted and negotiate the best deal you can.”

Pricing

Given the discussions that have taken place in recent months it seems reasonable to assume that the market has all but priced in the idea that the government will fail to get the negotiated deal through the House of Commons at its first attempt. Some sign of this came on Friday morning when GBP barely moved following a comment from former Brexit Secretary Dominic Raab that the UK Parliament would vote down PM Theresa May’s negotiated deal. The question therefore is what else is being priced in.

GBP started to stabilise late on November 15 as the idea of an imminent leadership challenge to UK PM Theresa May began to fade. With this potential distraction out of the way (at least for the moment) it was noticeable that GBP did relatively little for the next four trading days. This came despite comments from the Labour leadership downplaying the ideas of either a second referendum and a general election. This lack of response suggested investors had already concluded that both of these were low probability events.

Interestingly, GBP also seemed relatively unmoved by the comments from Mark Carney and other BOE officials on Tuesday, November 20. It’s also worth noting that the most significant move to emerge in GBP since the resignation of Dominic Raab (who held the role of Brexit Secretary) came on the back of a Reuters report highlighting the draft declaration on EU/UK ties post Brexit.

Given the uncertainty that a hard Brexit would entail and that GBP currently remains in reasonably well defined ranges against both the USD and EUR, it seems reasonable to conclude that this possibility is not being priced in as the most likely outcome by the spot market. Moreover, while it’s certainly true that prices are elevated in the options market are elevated, current levels of longer dated implied volatility show that the levels of stress are still down when compared to 2016, 2008 and even 2010.

This, in turn, suggests that the outcome most likely being priced into GBP right now is the idea of a successful second vote in Parliament on the negotiated deal and an orderly exit on March 29 (as suggested in the FT).

While it’s certainly possible that this will happen, it’s interesting to note that one of the arguments as to why it might is that “a significant financial market reaction” to the failure of the first vote would help concentrate the minds of MPs that voted against it, encouraging them to change their support the second time around. However, if the idea of a second vote is already being partially priced in then it remains open to debate quite where this “significant financial market reaction” would come from. It’s also worth considering whether there would any meaningful difference in what Parliament voted for given European Commission President Jean-Claude Juncker’s comments in the aftermath of the announcement of the negotiated deal.