Pound Sterling's Bad Week Just got Worse as UK's Irish Border Proposals Look set to be Rejected by EU Negotiators

- EU + Brexit opponents at home corralling UK into staying in customs union

- Longer-term implications for Sterling depend on UK's next move

- Pound already reeling from Mark Carney's interest rate comments

The prospect of the EU and UK crashing out of their union remains alive, with news headlines out on Friday, April 20 confirming that the Brexit milestones that have been reached during 2017 might all count for nought.

Bloomberg quotes three people familiar with the European Union position, as saying that the EU officials are set to reject a potential UK solution to the crucial issue of what happens to the Irish border after Brexit, deepening the stalemate in negotiations.

Key quotes from the report are:

“While the U.K. hasn’t made a formal proposal, it has indicated that the bloc’s “backstop” solution for maintaining an invisible border should apply to the whole of the U.K.

"But the European Commission opposes it and only wants to offer that special status to Northern Ireland.”

Finding a way to avoid customs checks on the border between Northern Ireland and Ireland after Brexit is proving the biggest obstacle for negotiators trying to get a deal on Britain’s divorce from the bloc.

Both sides maintain the line that nothing is agreed until everything is agreed, therefore failure on the Irish border will ultimately mean negotiations fail in total, and this is clearly bad for Sterling which is trading at levels that assume a deal will be reached.

Both sides do agree the withdrawal treaty must include a “backstop” on Ireland in case a better option doesn’t emerge from the final trade deal, they can’t agree on what it should look like.

Ireland and the EU appear to be unwilling to compromise on the matter and have set a clear read line on the Irish border; it appears to us that they are intent on corralling the UK into a customs union agreement.

This chimes with a recent move by the UK Parliament's upper house - the House of Lords - which this week sought an amendment to the Brexit bill that would force the Government into entering a customs union. The timing of the latest news would lead one to suspect there might be some element of coordination to pressure the UK Government into being more open to joining a customs union.

How the Government reacts will have significant implications for Sterling:

1) Capitulate and enter a customs union: Good for the Pound, with the general rule of thumb being that the softer the Brexit, the better it is for Sterling
2) Stick to their red lines: Bad for the Pound

The UK Government has been clear in its desire to exit the European Union customs union as remaining in the customs union does not allow the UK to negotiate trade deals with other non-EU countries.

The ability to do so is one of the foundations of the Brexit movement and we believe it unlikely the current Government would capitulate on this point.

Both the EU and UK are deeply entrenched in their stances and perhaps markets are yet to realise they might simply not budge and the chances of an hard, disruptive exit continues to grow.  

We believe the British Pound will fall sharply if this becomes more widely agreed.

“As the summer months approach, we see scope for concern about the progress of Brexit trade talks to weigh on the Pound and see risk for EUR/GBP to edge towards 0.89 on a 3 month view. That said, it is our house view that the bones of a free trade deal will be in place by March 2019. We expect that this should spark a push back to 0.84 on a 12 month view,” says Jane Foley, an analyst with Rabobank.

EUR/GBP at 0.89 gives a Pound-to-Euro exchange rate of 1.1235 while 0.84 give an exchange rate of 1.19. So their forecast profile could be summarised as: up, down and back up.

However, even this view might be too optimistic according to Europe's largest asset manager, Amundi.

Amundi believe there remains a chance Sterling could slip below 1.0 against the Euro owing to their belief that the EU and UK will ultimately reach an intermediate relationship that will be particularly harmful to the UK's dominant services sector.

"Our base case scenario foresees an intermediate relationship, with free trade in goods but only very partial passporting in financial services," says Didier Borowski, Head of Macroeconomic Research at Amundi, Europe's largest asset manager. "This limited access is the price the UK would pay for imposing major restrictions on movement of people and paying only limited contributions to the EU budget.

This view does appear to be increasingly consistent with the direction of travel of Brexit talks.

"If this outcome was to materialise we would expect the Pound to depreciate vs. USD to 1.30 and to a larger extent vs. EUR, to around 0.95," says Borowski.

At the time of writing the British Pound is seen under pressure amidst signals that the Bank of England is intent on stepping back from raising interest rates in May, today's Brexit headlines will only stir the pool of uncertainty.

The Pound-to-Euro exchange rate is seen trading at 1.1394, having peaked just below 1.16 earlier in the week.

The Pound-to-Dollar exchange rate is quoted at 1.4063, down from a high at 1.4376 registered earlier in the week.

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