British GBP/USD Rate Could Go Above 1.30 on a Good Transitional Brexit Deal: BofA

Pound Sterling could put a decisive floor under its post-Referendum spell of weakness if sober heads prevail in upcoming Brexit negotiations and a transitional deal is agreed ahead of the UK's final exit from the EU. 

The GBP/USD exchange rate could even move back above 1.30 in such an event we are told by a leading foreign exchange analyst argues. However, a look at 1.10 is possible should negotiators fail to agree on any transition.

The stakes are therefore high for those with large GBP/USD payments set for the coming year. 

The UK will have two years to negotiate its withdrawal and agree on a new trading relationship with the EU once the government triggers Article 50.

Most commentators agree that this is an impossibly short period to negotiate a replacement trade deal with EU Vice President Jyrki Katainen saying on Monday February 6 that It will require "a little miracle" for Britain and the European Union to complete negotiations on Britain's exit from the bloc in the two-year timeframe allotted.

It took the EU and Canada seven years to agree a deal, and while the UK and EU are far more integrated and determined to strike a deal on their new relationship, the threat of exceeding the two year slot looks high.

This raises questions for a currency perspective, particularly if we reflect that uncertainty is one of the prime drivers of current Sterling weakness.

Theoretically, the relationship between the EU and UK would be expected to default back to World Trade Organisation (WTO) rules should the deadline not be met.

But even here, clarity is not forthcoming,

"The UK will not automatically revert to full WTO membership on leaving the EU. The UK’s current membership is linked to its status in the EU and renegotiations with other WTO member states will need to take place over a number of complex issues," says Oliver Harvey, Macro Strategist at Deutsche Bank.

So if you cannot default to WTO, yet you miss your deadline, what can be done?

The obvious point to be made here is that the two year rule has been sucked out of thin air and there is no precedent in this matter and we would suggest it will be extended where necessary.

Analysts at Bank of America Merrill Lynch Global Research, think there is also a material chance of a transitional deal being worked out which offers a soft-landing alternative.

They see this as becoming a major issue for Pound Sterling in the short-to-medium term, especially once the market has moved on from hyper-focusing on the actual triggering of article 50.

The agreement of a transitional deal with the EU is therefore of prime concern in evaluating the future of the Pound.

The Cliff-Edge to WTO

BoFA’s FX Strategist Athanasios Vamvakidis says that although UK economic data has been remarkably strong post-referendum the real test will come with Brexit.

If a deal cannot be negotiated before the two-year deadline is reached the economy could be at risk of rolling off of a cliff-edge to a default WTO rule set, which would harm the economy.

In such a scenario, data would also be expected to decline sharply, and the Pound to depreciate even further, probably exacerbating the situation and leading to greater outflows of capital.

While we have noted this as being unlikely it must be pointed out that unless markets reach the same conclusion the impact of the Pound could be notable.

Game Theory

Using a branch of Economics called ‘Game Theory’ BofA make a case for there being a high chance that the UK and EU will manage to hammer out an interim trade deal and that the Pound will rise in the medium-term on the news.

Game theory is a branch of Economics which deals with how individuals rationalize and make decisions, and how the decisions of those around them impact on both actors’ outcomes.

The theory suggests that actors – or in this case dealmakers and negotiators – will chose the option which is the least risky for themselves.

Looking at the different possible outcomes during the Brexit process, BofA argue that it would seem rational for both the ‘actors’ in that ‘game’ (ie the EU and the UK) to avoid the risk of a WTO cliff-edge by opting for an interim trade agreement.

“Using game theory, we determine the conditions that make it rational for the UK and the EU to reach a transition agreement to allow time for a final trade agreement,” says Vamvakidis.

All the other possibilities have the negative risk attached that they could produce a hard-landing or ‘shock’ for the economy.

Effect on GBP/USD

The effect on the exchange rate of the brokering of a transitional trade deal would be for it to rise to above 1.30.

The penalty for not brokering a transitional deal would be a move lower to 1.10.

BofA note an increased willingness to consider the possibility of a transitional agreement in the UK.

“The growing consensus in the UK on the need for transition, or at least an implementation phase, has supported GBP recently. However, markets could also be disappointed. We are long GBP/USD vol.”

In a recent note, BofA strategist Kamal Sharma forecast Sterling to weaken in the short-term as Brexit worries “crystalize” after the triggering of article 50.

Longer-term, however, he sees the Pound appreciating, because “GBP looks cheap versus macro drivers such as the labour & property market and against the backdrop of improving global growth,” says Sharma.

Rationality

One problem with the game theory approach, however, is its assumption that actors will act rationally.

The referendum itself showed that public opinion arguably was not rational, as it chose to vote for the more risky ‘ideological’ option over the less risky status quo alternative.

In this case, the actors will first and foremost be professional politicians with a responsibility both to the country and their constituents, and it remains to be seen how they balance risks to the economy with the winds of public opinion.