British Pound Bulls Credit Suisse see Faith in Sterling Shaken by Irish Border Tussle

"If we are wrong, the asymmetry seems in favour of a rather sharp fall in the GBP amidst a potential double risk of "no transition deal" and "a collapsed government." - Credit Suisse. 

Strategists at Credit Suisse has walked away from an earlier bet that the Pound-to-Euro exchange rate will rise over coming weeks, saying the evolving risk-return profile of the trade means it is no longer a good idea.

At the heart of the decision is this week’s Brexit negotiation quagmire over the Northern Irish border, which saw Prime Minister Theresa May forced to abandon an announcement that “sufficient progress” has been made.

Markets were hoping May would agree the wording of an agreement on how to avoid physical infrastructure at the Northern Irish border; one of the three hurdles that Brussels negotiators say must be met in order for talks to move on to the subject of future trade and transition.

For talks to progress, there needs to be a unanimous decision in favour of moving on, at the European Council summit on December 14 and 15. With the date drawing closer and an agreement yet to be reached, the risk of “no deal” in December is growing.

“We have long had a relatively bullish GBP view based on our expectation that the UK government would fold on all key issues in order to tie up a transition agreement well before the end of Q1 2018,” says Shahab Jalinoos, a strategist at Credit Suisse.

The government’s confidence and supply partner, the Democratic Unionist Party, objected to the wording of Monday’s agreement concerning the Irish border, saying it would lead to Northern Ireland being treated differently to the United Kingdom.

They have since shown no desire to hasten a decision on subsequent ammendments to the document, indeed, according to press reports the DUP are saying progress on the matter this week is unlikely. This is a problem as the European Union has said a deal must be agreed by the weekend for leaders to give the go-ahead on transission agreement talks at their mid-December conference.

The timing of the DUP’s objection was reported to have been the result of the agreement having been held back from the DUP, whose leaders are said to have seen it in the press first.

“We suspect we will be proven right on the financial aspects of the UK's offer to the EU necessary to win a transition deal, but clearly the picture is very cloudy with the issue of the Irish border problem,” says Jalinoos.

The Credit Suisse team say it “seems an impossible task” to have the UK leave the customs union and maintain an open border with the Republic of Ireland without having some other kind of border between the UK and the island of Ireland.

This might require “regulation equivalence” between the Republic and Northern Ireland and, or, customs union membership for Northern Ireland, according to Jalinoos, who flags that the Northern Irish question has existential components to it on a number of levels.

“There is a potential major identity crisis not just for Northern Ireland (which may have to decide painfully if it's more British or Irish) but for the Republic (which has had an open border with Northern Ireland since 1922) as well,” says Jalinoos. “When matters of nationality are front and centre, and the history is long and sometimes turbulent, much is possible that is not necessarily economically rational.”

There are also other important spillover-considerations emanating from the Irish border questions. Such as, the relationship between the Scottish Conservatives and those south of the border which, necessary for the government to remain in power, is not guaranteed to hold if “special status” becomes an issue in Northern Ireland.

“We remind readers that the 1979 general election in the UK that brought Margaret Thatcher to power was a direct result of Scottish Nationalists pulling their support for the then-Labour government after a local referendum result was not implemented and a lost vote of confidence for that government,” says Jalinoos.

Credit Suisse has kept its current forecasts for the EUR/GBP rate in place, at 0.88 in three months and 0.86 in six months, which puts the Pound-to-Euro rate at 1.1360 and 1.1627 respectively.

“But if we are wrong, the asymmetry seems in favour of a rather sharp fall in the GBP amidst a potential double risk of "no transition deal" and "a collapsed government with an uncertain resultant general election outcome. This is why we no longer feel the trade has a worthwhile risk return profile,” says Jalinoos.

The Credit Suisse team had been using FX options, which are a financial derivative, to bet on a rise in the Pound-to-Euro rate since June. Closing the trade has resulted in them booking a return of around 7%.

Sterling was quoted 0.01% higher at 1.1339 against the Euro shortly after the London close. 

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Breakthrough Still Expected, and the Pound Could Still Therefore Shoot Higher

While Credit Suisse's strategists have clearly been shaken by the impasse over the Irish border,  Richard Falkenhäll, Senior FX Strategist at SEB, a leading Nordic corporate bank, still sees the Pound breaking higher on progress.

“Despite new set-backs in Brexit talks, we think there will be a solution which will pave the way for EU leaders to initiate stage two in talks when they meet next week (14-15 December)," says Falkenhäll.

Should this be the case, SEB's estimated Brexit risk premium suggests it would be followed by a generally stronger British Pound.

SEB target at least 0.85 in EUR/GBP on a solution that would break current deadlock in Brexit talks. This gives a GBP/EUR exchange rate of 1.1764.

“Time is running out but our-base scenario remains that leaders will come up with a solution that satisfies EU-leaders on 14 December, moving negotiations to stage two. We continue to expect any signs of a breakthrough in negotiations between the parties to boost the GBP by decreasing the Brexit risk premium," says Falkenhäll.

In SEB's view, the risk premium reflects the possibility that the UK will leave the EU without a deal in March 2019, a situation that would likely be extremely negative for the country’s growth outlook.

“If a divorce deal is reached, clearing the way for trade negotiations to start later this month, then the risk premium should be considerably smaller than it is today, as the potential negative impact on the UK economy of the country’s withdrawal from the EU will have been much reduced," adds Falkenhäll.

Get up to 5% more foreign exchange by using a specialist provider by getting closer to the real market rate and avoid the gaping spreads charged by your bank for international payments. Learn more here.