Northern Ireland's DUP Pose Significant Hurdle to May's Brexit Plans

Above: DUP Arlene Foster's response to any Brexit deal is key to Sterling's outlook. Image © DUP, Reproduced Under CC Licensing

- A brexit deal said to be close at hand

- But DUP's reaction is critical

- Pound-to-Euro exchange rate @ 1.1427, Pound-to-Dollar rate @ 1.3189

The British Pound is resting near recently achieved multi-week highs against the Euro and multi-day highs against the U.S. Dollars with the market apparently adopting a wait-and-see approach to an imminent Brexit deal.

Speculation that a deal is due in coming days has become rampant with some mid-week reports suggesting a deal could be detailed as early as Monday next week. However, there have also been no shortage of headlines that will urge caution amongst investors and prevent the Pound from getting carried away.

While progress in talks is being reported, opposition to the shape of the deal is also being reported, most notably over the issue of the shape of the backstop: It looks like the U.K. will agree to a customs union backstop to ensure there is no 'hard' border on Ireland, but Theresa May's Northern Irish DUP party backers appear ready to reject the proposals.

Without their support, pushing any Brexit deal through parliament is unlikely. Further, the DUP have threatened to withdraw support for May's government elsewhere, something that could well bring her government down.

"Despite some GBP bullishness on the prospect of a deal before next week’s E.U. leaders’ meeting, PM May’s coalition partner – the DUP – is again flexing its muscles by threatening to vote down the UK budget and potentially PM’s May leadership in early November if their wishes aren’t respected on the Irish border," says Chris Turner, a strategist with ING Bank N.V. in London.

The E.U. are clear in their determination for the Irish border question to be solved via checks on goods being conducted between Northern Ireland and Great Britain. In a speech made mid-week in Brussels, the E.U.'s chief negotiator Michel Barnier said:

"Both the E.U. and the U.K. exclude having a physical border on the island of Ireland. Therefore what will arrive into Northern Ireland will also be arriving into the Single Market.

"There will be administrative procedures that do not exist today for goods travelling to Northern Ireland from the rest of the U.K. Our challenge is to make sure those procedures are as easy as possible and not too burdensome, in particular for smaller businesses."

Barnier summary:
- EU not budging on checks on goods between GB/NI
- EU wants most to be streamlined as possible, behind the border
- However, live animal and animal origin product checks MUST happen at border. This happens already but only on 10% of it. Now must be 100%.

— Charlie Cooper (@CharlieCooper8) October 10, 2018

The proposals form part of the Irish "backstop", which is intended to take effect if the two sides fail to agree on alternative arrangements to avoid a hard border in Ireland.

Barnier maintains the plan is a "safety net" and "the future relation in itself might mitigate the necessary checks or even make some unnecessary." He also suggested that a deal was likely next week, provided agreement on this proposal is achieved.

If Barnier's position is agreed by the U.K., the DUP's response will be key.

If they withdraw support for the U.K. government - indeed there are threats to vote down November's budget - then political uncertainty will skyrocket.

You can bet Sterling will bear the brunt of any deterioration in sentiment.

"The risk of a no-deal Brexit is still considered high, judging by the option premium to protect against deeper GBP declines and why GBP bulls are better served by options than by more vulnerable cash," says Richard Pace, an analyst at Thomson Reuters.

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Markets Increasingly Optimistic

While nerves are certainly elevated - and this is keeping enthusiasm for Sterling in check - markets are nevertheless cautiously betting that a deal that does enough to satisfy all parties will ultimately emerge.

As a result, the Pound is the best-performing G10 currency of the past month:

The gains take Sterling well above where consensus are forecasting the currency to end the year against both the Euro and Dollar. Horizon Currency Ltd have curated a report detailing where these forecasts lie, including the targets of big-names like Goldman Sachs, Citi, Barclays and HSBC. (GBP/USD forecasts here, GBP/EUR forecasts here).

"The mood music emanating from Brussels is leaning towards a Brexit deal. It looks like the E.U. is finally keen on giving Theresa May the loosest possible backstop on Northern Ireland, stressing how unlikely it is that any backstop would be triggered. Sanity, perhaps, is finally prevailing, in a manner that experienced Eurocrisis watchers will recognise," says Chris Beauchamp, Chief Market Analyst at IG.

Looking at the structure of the futures market (the market in currency contracts built on expectations for future currency moves) we can see there are increasing expectations for a positive outcome.

"Demand is picking up for GBP call options, with 1.3500 a popular strike across a range of maturities," says Pace. A call option is a contract that anticipates a move higher in an exchange rate.

"Chances of a Brexit deal have improved; some are even touting an agreement by next week's European Union summit. The initial GBP reaction to an agreement would be positive, but how much GBP would benefit is unclear, since the UK parliament would still need to approve the proposals before their official ratification," adds Pace.

According to Pace, of option flows are any gauge, then 1.3500 is within scope, with several buyers of strikes between 1.3250 and 1.3500 maturing after the summit.

"We note that while positioning and Brexit headlines have been a source of stress for GBP, our HFFV gauge has shown that fundamentals have been improving. Currently, HFFV points to a move back to 1.35, suggesting a short-term bullish stance towards GBP," says Mark McCormick, North American Head of FX Strategy with TD Securities.

For the remainder of the week we expect traders to be glued to the newswires and digesting the rumours and counter-rumours regarding negotiations. The big moves are however likely to be delivered next week when officials step up to the podium.

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Lock in Sterling's current levels ahead of potential declines: Get up to 5% more foreign exchange for international payments by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here