The Pound Zig-Zags as May Yields to Davis on Customs Backstop: Brexit Intrigue is Back for Sterling

© Number 10 Downing Street

Pound Sterling was seen to be back to trading rumours and headlines regarding Brexit: on Thursday, June 7 we witnessed the currency zig-zag in response to news snippets coming out of 10 Downing Street as the government thrashes out a compromise in order to reach an unified position on the matter of the European customs union.

We saw this type of eratic response by Sterling to political angist in 2017, but believed markets were keen to avoid making any directional decisions on Sterling over Brexit rumours in 2018 instead opting to wait for concrete announcements and developments.

But, it appears the issues being ironed out at at present are too important to ignore and Brexit newsflow is being tracked by the market once more.

The text of the "Technical note on temporary customs arrangement" published following a much-watched meeting of the cabinet confirms Theresa May has given in to her Brexit secretary David Davis over a key point in the administration's Brexit policy on customs.

At question is a so-called "customs backstop" regarding the Irish border - a fall-back where the UK and EU agree to maintain existing customs settings in lieu of a decisive agreement being found in Brexit negotiations covering the matter of the Irish border. The need for a fall-back appears increasingly likely considering how fast the October Brexit negotiation deadline is approaching.

At the heart of the matter is the question of how long any backstop would last - it is understood that some factions in the cabinet wanted it to be subject to an open-ended timeline; others including Brexit Secretary David Davis wanted a clear end date.

According to the agreed text, the backstop agreement for the post-Brexit Irish border “should” end in December 2021.

Sterling initially didn't like the concession made by May to Davis, apparently the idea of an indefinite membership of the customs union was a preferred outcome for markets and is deemed to be a 'soft Brexit' option.

Rumours had been rife through the mid-week session and into Thursday that Davis would quit over the matter, leading to the potential for instability in the current administration which would be taken by markets to be a significant negative for Pound Sterling.

"A small government crisis plus more disagreements with the EU27 ahead of the EU summit plus time limited backstop is worse than unlimited backstop from an economical point of view, the result is EUR/GBP moves higher and GBP/USD lower," says a response to the latest developments from currency analysts at Danske Bank.

However, Sterling ultimately ended the day higher, suggesting markets ultimately remain in wait-and-see mode when it comes to Brexit developments.

"Intra‑day volatility has spiked, but GBP/USD has held up relatively well trading around 1.3420 considering the political pressure being applied to Prime Minister Theresa May after she delivered her Brexit custom’s union proposal," says Richard Grace at CBA in comments made ahead of the weekend.

The Pound-to-Dollar exchange rate now quoted at 1.3420 having been as low as 1.3373 on Thursday, the Pound-to-Euro exchange rate is at 1.1367 having been as low as 1.1314 on Thursday.

Accusations of a Fudge ABound, but a Fudge Might Just be a Good Thing

The compromise over the backstop plan being reached between the two factions in the UK cabinet is being widely described as "a fudge" - a negative assesment of the outcome by the commentariat who would most likely have wanted something more exciting, for instance a resignation.

"Ok now it’s over. Backstop wording has been changed, but still no firm date for the time limit. An ‘expectation’ when it should expire, to be agreed with Brussels. So, a massive fudge on both sides," says Tom Newton Dunn, Political Editor at the Sun.

Of course this is all classic Westminster bubble stuff: some might view this as a fudge, others as the outcome of a negotiated compromise on what is potentially one of the hardest puzzles encountered by politicians in modern British politics. 

Regardless, for markets the uncertainty of it all is what matters.

Brexit has again become an issue for foreign exchange markets following a multi-month hiatus because we are fast approaching a number of deadlines - namely the two summits of the European Council which sees the leaders of Europe assembled to discuss a host of issues, Brexit being one of them.

I welcome publication of #UK proposal on customs aspects of IE/NI backstop.
We will examine it with 3 questions: is it a workable solution to avoid a hard border? Does it respect the integrity of the SM/CU? Is it an all-weather backstop?

— Michel Barnier (@MichelBarnier) June 7, 2018

With the June summit fast approaching, the time for the UK to make big decisions is fast fading, and foreign exchange markets will soon have substantive news on the matter to trade. For now, the issue remains more of an hinderance for Sterling more than anything else, and as has been the case for the past two years, we await clarity on what Brexit will look like.

"We can’t be optimistic about the Pound until we get further clarity on the current issue holding up the negotiations – the plan for the border in Northern Ireland. This plan was supposed to have been passed to the EU yesterday but this did not happen. There are reports that David Davis disagrees with the content of the plan covering the backstop scenario," says Halpenny.

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