Pound Fades on Fresh Brexit Deadlock but Weakness to be Contained

• Spot market quotes:
• Pound-to-Euro exchange rate: 1 GBP = 1.1277 EUR
• Pound-to-Dollar exchange rate: 1 GBP = 1.3769 USD

© European Union , 2018 / Source: EC - Audiovisual Service / Photo: Mauro Bottaro

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Pound Sterling enters March on the backfoot as markets judge recent developments concerning Brexit as having raised the prospect of the EU and UK failing to reach a transitional deal in March.

Whenever concerns over Brexit spike, the Pound tends to fall, but we would caution that what we are witnessing is typical posturing that both the EU and UK tend to enter into ahead of ultimately meeting their next negotiating deadline.

As such, damage to the Pound might be contained.

The latest bout of Brexit nerves comes as the European Union formally demands Northern Ireland remain within the European Union's customs union after Brexit should no credible solution to the border issue be found. The position was communicated in a draft legal paper covering the withdrawal of the UK from the EU released on Wednesday, February 28.

The EU communicated they believe no credible solution has yet been forthcoming, suggesting an impasse is brewing.

The developments saw a strong rebuttal from the UK government and all Northern Irish Unionist parties who see the EU adopting a reckless stance towards the UK's own constitutio which risks driving a wedge between Northern Ireland and its largest trading partner and market - the United Kingdom.

"The draft legal text the commission has published would, if implemented, undermine the UK common market, and threaten the constitutional integrity of the UK by creating a customs and regulatory border down the Irish sea, and no UK Prime Minister could ever agree to it," Prime Minister Theresa May told parliament.

The move raises the prospect of the two sides failing to establish a transitional Brexit agreement in March, the need for a transitional agreement is something Sterling has proven particularly sensitive to.

"Squeaky bum time for GBP, big few days of Brexit headlines," warns Viraj Patel, an FX strategist at ING Group who sees the potential for some volatiliy in Sterling emerging over the matter in the short-term.

Indeed, Sterling has edged lower in following the release of the legal document, but the decline is relatively unremarkable in the context of previous Brexit-induced slumps which suggests for markets are still quite relaxed.

Patel says if GBP/EUR comes back above 1.1337 and GBP/USD back above 1.3850 it would be confirmation that Sterling is pretty resilient and becoming immune (in the long-run) to Brexit headline risks.

"Either the Pound's got a solid chin or these Brexit blows aren't big enough to take the currency down," says Patel.

We watch and see if these levels can in fact be recaptured in early March to confirm Patel's thesis.

Transition Period at Risk, but EU Could Concede

The end of March is a key moment for Sterling, as this is when an implementation period is set to be formally agreed by both the EU and UK; missing this deadline would trigger problems for Sterling.

The EU's Michel Barnier told the press following the release of the legal draft that the EU still looks forward to receiving the UK's proposals on how to avoid a hard border on Ireland but stressed he still believes EU rules must be closely followed, something which effectively keeps Northern Ireland locked with the EU.

Because of outstanding disagreements, Barnier maintained that a transition period is not a given; something that will certainly be weighing on Sterling and it remains the case that Northern Ireland is the key source of contention that could drive a failure to reach an agreement.

Markets believe a transitional deal will provide businesses with certainty about what the future relationship will look like, as well as time to prepare for it. Both sides agree negotiating the future relationship will take time to be agreed and that most of the work can only begin after March 2019, meaning there will probably only be very limited preparation time for businesses.

"On Ireland, we need to ensure that there will be no checks at the border and protect the Good Friday Agreement in all its dimensions. By creating an area with common rules between the Union and Northern Ireland, we achieve our objectives," reads the document.

Northern Ireland's DUP leader in Parliament Nigel Dodds says he is amazed by the proposals and says they are "quite offensive" and confirms the DUP will reject the proposals and believes the Government will reject the proposals.

Northern Ireland's DUP is a key ally of Theresa May and one of the two key players in Northern Ireland and will certainly not support the UK government in parliament were a the UK to accept the EU's demands.

Dodds notes there is some way to go in negotiations and it he expects the proposals to be dropped.

Indeed, on Thursday, March 1 the BBC's Adam Fleming reports that EU Council President Donald Tusk will ask Prime Minister Thersa May "if she has a better idea to avoid a hard border between Northern Ireland and Ireland than the EU's proposal for a single regulatory area."

Importantly Fleming reports Tusk as saying member states "will approve most elements of the draft text". There is therefore wiggle room here and Tusk has hinted that changes will be made.

Jeremy Corbyn should know that we needed a hard border 30 years ago to stop semtex not powdered milk. I want to see a sensible Brexit, a frictionless border with RoI and no new border in the Irish Sea between NI and GB. #corbynflip https://t.co/adBWk7jdxz

— Arlene Foster (@DUPleader) February 26, 2018

We would expect recent ranges in the various Pound exchange rates to be maintained but expect a more sizeable move higher or lower depending on whehter that transitional deal is secured. “The narrative that has been priced into GBP markets this week is one of no real Brexit consensus emerging between UK and EU officials – and so we suspect GBP, under this new Brexit trading environment, may be fairly immune to negative headline risks,” ING’s Patel writes in a note to clients.

However, others aren't so optimistic.

“I expect that the collision between the irresistible force of Brexit and the immovable object of EU unity will wind up shattering GBP, at least for the time being,” says Marshall Gittler, chief strategist at ACLS Global.

All eyes now turn to Theresa May who is to deliver a speech on Friday, March 2, detailing the UK's latest position regarding negotiations and desires for a future trading relationship.

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