Brexit Update

Three and half years after what was initially a non-binding referendum, the UK has seen its way to leave the EU.  The House of Commons passed the necessary legislation last week as Tories enjoys a parliamentary majority.  The House of Lords takes up the measures now. Although the Conservatives do not have a majority and a vigorous debate is expected, the unelected body is most unlikely to block Brexit.  

What happens next?  The UK will formally exit the EU at the end of the month.  It enters an 11-month standstill phase.  Nothing changes.  The UK and the EU will negotiate their new trade relationship.  Here is where the risks are to be found.  

First and foremost, after Brexit was bedeviled by embarrassing delays and setbacks, and Prime Minister Johnson, having re-gained majority, insists that the trade talks are completed by the end of 2020.   This is an ambitious timeframe and may speak to the government's limited agenda.  It is insisting on two big things:  it will not accept free movement or commit to regulatory equivalence.  Even if the negotiations are smooth and the best case materializes, the UK's access to the EU market will be either more limited or more expensive and, most likely, both.  This has important implications for businesses who use the UK as their entry into the Continent.   

The new EC President von der Leyen, the EU's Brexit negotiator Barnier, and several other European officials have pushed back against Johnson's schedule.  However, for different reasons, German Chancellor Merkel and French President Macron may insist on a less confrontational approach.  The attitude after the UK election seems to be fully accepting the facts on the ground. The UK is leaving the EU.  Let the new era begin. Up until now, the EU has shown a remarkable unanimity in the tortured Brexit course.  There have been no defects from the united front.   

Second, the Irish border remains a thorny problem.  In effect, the UK has promised to operationalize a computer system for the special arrangement of the Northern Irish border and does not have the support of any Northern Irish political party.  However, until a final trade agreement is struck, the details of the border arrangement cannot be finalized: a genuine conundrum. 

Third, if a new trade deal nor an extension of the standstill period can be agreed upon, the UK would exit the EU at the end of 2020 on the terms agreed upon as members of the World Trade Organization.  This has been what many have meant by a hard-exit.  A basic tenet of the WTO is the most-favored-nation principle that obligates members to treat the same good alike but allows for exceptions in the case of a broad trade agreement (such as NAFTA/USMCA or CETA, the EU-Canadian Free-Trade Agreement).  The UK has a few negotiating chits, including its fisheries.

After the standstill period expires and if no trade agreement is struck, UK imports from the EU and EU imports from the UK are ostensibly to be at the level that the EU charges other countries with whom it does not have a free-trade agreement.  The alternative is for the EU and UK to lower the tariffs with the rest of the world dramatically, but of course, this is the less likely scenario.  UK trade lawyers may argue for an exemption as were granted under the WTO's predecessor (General Agreement on Tariffs and Trade) for former British and French colonies. Still, the EU is unlikely to accept this and appears less vulnerable than the UK in such a situation.  

Fourth, while the EU has many trade arrangements, the UK has been prevented from negotiating bilateral agreements.  The Johnson government has prioritized a free-trade deal with the US.  Despite US President Trump's support for Brexit generally and Johnson, in particular, a UK-US trade deal may not be so easy.  Even before negotiations have begun,  America's "chlorinated-washed chickens" have come under attack, and protecting the National Health Service (NHS) from US contractors been promised.  At the same time, a generous trade agreement may go against the grain of "America First" and, the Trump Administration seems to place economic rivalry above nearly all else.  It did not give the UK any breaks in its retaliation against what the WTO said were improper subsidies for Airbus.  

Brexit is no longer moving the markets, and the new trade talks have not begun.  More importantly, in the near-term has been a change of tone by a few members of the Bank of England's monetary policy.  The recent string of data suggests that the uncertainty over Brexit may have weighed on the economy more than anticipated.  While the Tory government has promised fiscal support, it will take some time to implement.  The budget will be presented on March 11.   

There seem to be at least four members of the MPC that are leaning toward.  Haskel, the newest member, and Saunders, who Bloomberg regards as the most hawkish member, have dissented at the last two meetings in favor of an immediate rate cut. Recent comments by Vieghe and Tenreyro suggests their patience with the soft data is coming to an end.  Of the nine-person committee, Governor Carney may cast the deciding vote, and reports suggest that the Governor votes last.  

Another consideration when assessing the potential action by the BOE is the upcoming change in leadership.  After a couple of extensions, like Brexit itself, Carney will step down on the Ides of March.  That means that the meeting on January 30 is his last.  The next meeting is not until March 26, which Andrew Baily will preside.  If Carney does not cut this month, it would possibly and maybe even likely put the new Governor in an awkward position of having to cut at his first meeting.   On the one hand, acting decisively can bolster a street cred.  On the other hand, easing policy makes it harder to be identified with strong money, as if that is still needed in our era of low inflation and low interest rates.  

Investors have recognized this risk and have adjusted their expectations accordingly.  They have doubled to a little less than 50% chance of a BOE cut this month and about the same for the March meeting.  Sterling is caught between the changing outlook for the Bank of England (bearish) and the expected demand from asset managers believed to be underweight sterling.  The chances of a rate cut may see sterling underperform in a soft US dollar environment. 

With the election, the passage of the Brexit bills in the House of Commons was widely expected.  The market appears to have priced in a great deal of good news.  The gross and net long speculative position in the futures market is the largest since Q3 18.  The $1.28-$1.29 area offers important chart support, and the average since the start of the last year is about $1.2770.   

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