Brexit Deal Hinges on U.K. Securing a Time Limit to the Backstop

Above: Domic Raab is said to be holding out for a time limit to be applied to any backstop. Image © European Union, 2018 / Source: EC - Audiovisual Service / Photo: Lukasz Kobus.

- Shape of imminent Brexit deal becomes clearer

- U.K.-wide backstop being mooted

- Hammond eyes boost to economy if deal is struck

- Pound-to-Euro exchange rate @ 1.1416, Pound-to-Dollar exchange rate @ 1.183

The British Pound treads water as a nervous market digests the latest news concerning an imminent Brexit Withdrawal Agreement and eye a series of key Brexit meetings over coming hours and days.

There is reason to be nervous amidst reports that any Brexit deal that includes a backstop proposal without a time limit will face a mutiny amongst Conservative party ranks, and there is even talk of senior resignations.

Britain's Chief Brexit negotiator Dominic Raab is reportedly unwilling to endorse a Brexit deal which does not include a set time limit on customs union membership in the backstop agreement.

Sensing danger, the Prime Minister's office has confirmed it would not seek any deal that included an indefinite backstop. The obvious question now is whether this is something the E.U. can accept?

The E.U. has already conceded to a U.K.-wide backstop agreement to kick in if the two sides are unable to formalise a trade deal within the two years of the transition period.

This ensures Britain and Northern Ireland will remain wedded and will likely eliminate any resistance to a Brexit deal from Northern Ireland's DUP which has made the issue of U.K. unity a "blood red line" in their Brexit stance.

So where there is progress, there are also new roadblocks.

The agenda for the E.U. 27 ambassadors' meeting in Luxembourg on Friday does however mention the drafts of a Withdrawal Agreement and Political Declaration on the future relationship being present. This suggests a deal will be put before them ahead of the weekend which is then passed onto European leaders at next week's E.U. Summit, starting October 17.

"The agenda for the E.U. 27 ambassadors - Permanent Representatives - meeting in Luxembourg on Friday mentions drafts of Withdrawal Agreement and Political Declaration on the future but that's no guarantee those docs will actually materialise," says Adam Fleming, the BBC's Brussels reporter.

The general sense is that negotiators are nearing the finish line.

"The Pound continues to benefit from increased optimism around a Brexit deal, which could come in the days ahead," says a note from the research desk at LMAX Exchange. "There is no first tier data schedule on Friday, though this market will have plenty to chew on as it contemplates the state of Brexit and the state of global sentiment."

Therefore, the outcome of this meeting will likely be one of the main events for Sterling ahead of the weekend: If those documents do materialise then we should have a deal and a 'no deal' Brexit is avoided, a situation that will likely benefit Sterling. 

"It could provide tailwind for the Pound if a no deal Brexit outcome is avoided in the coming months. In these circumstances, we continue to believe that the pound could still strengthen by a further 5-10%," says Lee Hardman, a foreign currency strategist with MUFG.

At present the Pound is trading above where consensus forecast it to end the year against both the Dollar and Euro. To see where consensus lies, and where big-names like J.P. Morgan, Goldman Sachs, Citi and Barclays are targeting GBP/EUR and GBP/USD please see the special reports compiled by Horizon Currency Ltd. (GBP/EUR here, GBP/USD here).

Backstop Agreed

The Telegraph reports the E.U. have agreed to an all-U.K. backstop which will be triggered in the event of no trade deal being struck during the two-year transition period.

This crucially means there is no Irish backstop and the integrity of the U.K. should be guaranteed; recall that it was fears of a divergence between Britain and Northern Ireland that lead Northern Ireland's DUP to threaten to vote against the government's budget, which would ultimately likely bring the government down.

That the U.K. will remain united could well unblock the resistance being put up by the DUP, and ensure the government survives and a deal is pushed through.

But the price to pay for the U.K.-wide backstop is said to be that there would be no time limit on the backstop's longevity.

Hard Brexiters fear that this means the U.K. could ultimately be locked into an E.U. customs union indefinitely, and the opposition from Brexiteers is likely to be a source of angst for the market.

Technical indicators for $GBP do not look poor, but potential outside down day today. The close is important, and yesterday's low just above $1.3180 is key. The closer May is to EU agreement the greater the tensions within her cabinet.

— Marc Chandler (@marcmakingsense) October 12, 2018

"Theresa May faces Cabinet revolt over customs backstop after it emerges it will not include a hard time limit or end date," reports Steven Swinford, Deputy Political Editor at the Telegraph. "Eurosceptics fear the concession could tie the U.K. to the customs union indefinitely."

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.

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Hammond Eyes Economic Boost to Deal Being Struck

The U.K. Chancellor Philip Hammond has meanwhile said he has seen a "measurable change of pace" in Brexit talks.

In a radio interview Hammond said there were still hurdles, but the "process" was much more positive and a deal could be imminent.

The Chancellor noted that if a deal is done, the UK could enjoy a "deal dividend" which would "deliver us an upside" for the economy.

Speaking at the IMF's annual meeting in Bali, Mr Hammond said that the UK's official economic watchdog, the Office for Budget Responsibility, had forecast economic growth as slowing because of Brexit uncertainty and the risk of a no-deal outcome.

But, if there is a deal, the OBR would be likely to upgrade that forecast.

"I believe there will be a dividend, a deal dividend for us," Hammond told the BBC.

He added:

"The OBR's forecast, which is the basis of our current projections for the economy and our fiscal position, is based on pretty much a mid-way point between no deal at all and an EEA solution.

"The deal that we're trying to negotiate with the EU now represents an improvement from the point of view of the British economy over that mid-point and therefore should deliver us an upside in the form of higher economic growth and better outcomes than were otherwise anticipated."

With expectations for stronger economic growth stemming from a Brexit deal, it is understandable that the fundamental backdrop underpinning Pound Sterling would improve.

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