Pound Sterling Firms on Euro & U.S. Dollar, May Tells Lawmakers Brexit Divide can be Briged

Above: Theresa May addresses the House of Commons on the state of Brexit negotiations. Image © Pound Sterling Live

- Brexit deal unlikely this week

- Markets still confident a deal can be done before year-end

- May holds out for time limit to a U.K.-wide backstop

Pound Sterling edges higher on Tuesday, October 16, recovering off the floors set the previous day with markets displaying a rather sanguine response to news that a long hoped-for breakthrough in Brexit negotiations would not be achieved this week.

Indeed, expectations are high that European leaders will at this week's European Council summit announce a new summit in November to finalise talks with a potential deadline in December being considered.

In short, there are a number of weeks of negotiations left and this has kept expectations for the disruptive 'no deal' Brexit in check.

Nevertheless, some see chances of a 'no deal' materialising; not least because any deal agreed with the E.U. could struggle to be passed through the U.K. parliament where resistance from a plethora of factions awaits.

"The risks are to the downside as the chances of a “no deal” Brexit have risen considerably over the past few months. Indeed, we think there is now an almost 50/50 chance that the UK leaves without a deal, which we estimate could knock off between 1 and 3ppts GDP growth next year," says Ruth Gregory, Senior UK Economist with Capital Economics.

Prime Minister Theresa May addressed the House of Commons on the afternoon of Monday, October 15 saying both the E.U. and U.K. are in agreement any Irish or U.K. backstop clause in any Brexit Withdrawal Agreement must be temporary in nature.

The confirmation from the Prime Minister signals that the gap between the two sides is not as gaping as feared, and suggests Sterling might be saved from a the kind of punishing sell-off that would be expected if markets feared a 'no deal' Brexit was becoming increasingly likely.

May told the Commons that she would not allow Northern Ireland and Great Britain to be split under any backstop agreement proposed by the E.U. The backstop clause is designed to keep the border between Ireland and Northern Ireland open by keeping the two Irish territories aligned under E.U. trade law.

Indeed, May said it would breach the constitution of the U.K. for Northern Ireland and Great Britain to separate into seperate customs regimes.

May says the E.U. have responded positively to the U.K.'s suggestion that the entire U.K. be included in the backstop deal ensuring U.K. unity. May's stance could do enough to ensure she can rely on her Northern Irish partners in the DUP to continue supplying the votes in parliament required to keep her Government in power.

The Prime Minister confirmed her side is negotiating from the position that the U.K. will not be trapped permanently in a backstop arrangement, any backstop should be temporary; it cannot be indefinite.

Importantly, May says both the E.U. and U.K. agree any backstop clause must be temporary, something that will ease concerns amongst that contingent of the Conservative party who might consider ousting her to guard against any perceived Brexit betrayal.

Any deal agreed on these terms would therefore likely secure the backing of her own lawmakers that would allow it to be voted through parliament.

For markets, May's tone is decidedly more constructive than was the case on September 21 when she delivered as stinging rebuke to the E.U. following the Salzburg summit and declared Brexit negotiations had reached an impasse. Sterling slipped over 1.0% following that address.

Pound Sterling's losses at the start of the new week are more contained, the Pound-to-Euro exchange rate is trading at 1.1351 having opened at 1.1391, the Pound-to-Dollar exchange rate is trading at 1.3140, having opened the week at 1.3151.

No Breakthrough Likely this Week

The soft start to the week for the U.K. currency comes as heightened expectations for an imminent Brexit deal to be announced are dashed following a failed late Sunday push by the two principle Brexit negotiators to deliver the progress required to make a deal possible at this week's E.U. summit.

The U.K.'s Dominic Raab and the E.U.'s Michel Barnier met in Brussels on Sunday, October 15 for an unscheduled meeting to try and break the deadlock in negotiations but the efforts failed to yield success.

Above: E.U. chief Negotiator Barnier confirmed Sunday more work had to be done to achieve a Brexit deal. Image © European Union , 2018   /  Source: EC - Audiovisual Service.

"There's no bad news, just a lack of good news," one diplomat told the BBC's Brussels correspondent Adam Fleming: the phrase perfectly summing up the state of negotiations and the state of currency markets.

While we're unlikely to see a deal being done this week, a deal is still likely before year-end.

"Sterling has moved lower on the news, but the market hasn't thrown its toys out of the pram yet. The adjustment lower really just resets the optimism of last week, with it likely to need some downhearted commentary from U.K. and European diplomats at the European Council summit this week to drive it significantly lower," says Mark Palmer at Hamilton Court FX.

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News that a deal is unlikely to reached this week will nevertheless disappoint Sterling bulls who had been looking for a stronger exchange rate in anticipation of an announcement coming as early as today; indeed there were expectations of some sharply higher levels being on offer had the two sides confirmed a deal had been struck.

But, that negotiators are not quite there yet will not surprise seasoned Brussels watchers - this pattern fits a template that shows the E.U. will ultimately negotiate down to the wire, and we feel that 'wire' is set in November. We expect to hear details of a November E.U. summit being called at this week's European Council Summit, which starts on Wednesday.

"The European Council meeting was meant to sign off on the deal on the UK’s exit from the E.U. However, that timetable has now slipped, with both sides talking about mid-November as a more likely point for sign-off on a deal. However, a proposed November meeting will take place only if EU leaders agree that sufficient progress on the question of the Irish border and future trading relationship has been made, so while this meeting is not quite the definitive one that it was initially meant to be, nonetheless it remains a key milestone in the Brexit process," says Sue Trinh, a foreign exchange strategist with RBC Capital Markets.

There is a very high probability that the E.U. will agree to a November deadline; they have too much skin in the game to give up now, failing to reach a deal with the U.K. would be tantamount to one of the worst diplomatic failures in the E.U.'s history and we believe they will do what is necessary to ensure a deal is reached.

Press reports suggest no further major negotiations are likely ahead of the E.U. summit as both sides will be looking for further guidance from European leaders. Patience is therefore required and it could be that the currency now finds itself cast adrift for some weeks.

Sterling would need to fall a little further against both the Euro and Dollar if it is to meet the year-end consensus forecasts laid out by 50 of the world's leading financial institutions and investment banks. According to a report on the matter, available from Horizon Currency Ltd, the currency is above levels forecast by the likes of Citi, Goldman Sachs, HSBC and Barclays. The GBP/EUR consensus forecast report is available here, the GBP/USD report here.

What's Stalling the Deal?

There is one fundamental problem that the two sides apparently cannot fix: the question of the Irish border.

There is hope that a mechanism that allows the border to remain open following Brexit will be agreed by the time the two year transition period ends in 2021, but should this not be achieved the U.K. and E.U. have agreed a backstop mechanism whereby Northern Ireland stays aligned with the E.U. in order to ensure the border remains open.

The U.K. is apparently seeing for the entire U.K. to be included as this will mean the U.K. is not broken up. At the same time, they want a time limit to the duration of the deal.

Prime Minister Theresa May needs the above conditions to be met in order to survive opposition from her Northern Irish partners in the DUP and her own Conservative party critics who want a clean Brexit that does not risk breaking the constitutional integrity of the U.K..

"One alternative for PM May is a UK-wide backstop, which would keep the whole country in the Customs Union in the event of no future deal. At first glance that might sound positive. But this may not get through Parliament or it may trigger a leadership challenge from the Conservative Brexiteers," says Rory Manley a trader on the Macro Sales desk with investment bank UBS in London.

The answer to this the securing a time limit to any U.K.-wide backstop which will ensure the country is not perpetually left subject to E.U. rules.

Will the E.U. agree to such a request? By all accounts no; the Irish government are just one party pushing for the backstop clause to be indefinite.

But something has to give and we believe the E.U. has more to give away than the U.K. - May now has her back against the wall and cannot go further. Simply put, she will be gone or her plans won't make it through parliament if she cannot deliver a Brexit deal that guarantees a time limit on the backstop.

The E.U. will surely recognise the negotiations achieved to date will come to naught if they can't agree something that has a chance of getting through the U.K.'s parliament.

So while a Brexit deal is still likely, it won't come easy and importantly for foreign exchange markets this means lingering uncertainty that will keep the Pound flighty.

"The risks are still skewed towards GBP downside in the short term," says Manley. With the risk of disappointment still hanging in the air, Manley is looking to buy EUR/GBP for a one month duration via FX options.

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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