Pound Sterling and May's Brexit D-Day: Potential Moves vs. the Euro and US Dollar

- British Pound to maintain familiar levels if May delivers another Brexit 'muddle'

- "The market should reward GBP" if May can win over Gove and Johnson to follow her
path

- Pound-to-Euro exchange rate could hit 1.1428 initially on positive outcome

Above: Yesterday's meeting where Theresa May updated Angela Merkel on her plans for a future trading relationship. Image © Number 10 Downing Street

UK Prime Minister Theresa May has reached a critical juncture in a premiership that will be defined by Brexit as she is finally due to set out the UK's preferred position on the future trading relationship between the UK and EU.

She will navigate a meeting of her cabinet at the Prime Minister's official country retreat - Chequers - where she will be hoping to thrash out a settlement between the soft-Brexit and hard-Brexit factions to arrive at a unified UK position.

With the "new customs partnership" and "maximum facilitation" options for a future trading relationship both seemingly rejected, a 'third way' is up for debate; details of the plan have been scant but over the past 24 hours it appears her key ministers - as well as the German Chancellor - have seen the plan.

Media reports suggest May is planning to enable regulatory alignment with Europe - thereby avoiding a hard border with Ireland - while keeping enough distance to enable a trade deal with the U.S.

The negotiations will culminate in a government White Paper, due for release early next week that will be pored over by Brussels whose initial reactions will be monitored by foreign exchange markets.

For Sterling, the risks are high.

"Brexit talks are heading into extra time – and unfortunately there won’t be any penalty shoot-out to save the Pound if Mrs. May is unable to find a last-minute winner this time around," says Viraj Patel, a foreign exchange strategist with ING Bank N.V. in London.

ING say May faces a predicament that sees her trying to achieve three simultaneous objectives:

(1) appease Brexiteer MPs within her own party;
(2) find a solution that a majority of MPs in the House of Commons would back; and
(3) find an outcome that is politically suitable for all EU members to accept.

"When push comes to shove, we think the PM will only be able to choose two of these three objectives – and the broader trajectory for GBP will be a function of her choice," says Patel.

Consensus expectations suggest the meeting will ultimately result in May pressuring her colleagues to accept further dilution of former red lines which include not accepting a customs union, not accepting a single market and not accepting the jurisdiction of the European Court of justice.

The reaction by those members of government and her party advocating for a pure Brexit will be key in that the unhappy faction could well trigger a leadership challenge to try and ordain a PM more sympathetic to their view; The Times reports that May faces the worst rebellion of her leadership as cabinet Brexiteers attempt to force her to push for a harder exit from the European Union than she is planning. 

Seven cabinet ministers are reportedly set to oppose her plans.

"One way or the other things will remain tense in British monetary and Brexit politics, and I fear that in the end Sterling will have to bear the brunt," says Antje Praefcke with Commerzbank.

The Way Forward for the Pound

If May, fearful of any Brexiteer backlash, withholds a clear decision and maintains a distinct air of ambiguity over the government's path Sterling will likely trade familiar levels as the can is kicked down the road.

"A continued 'muddling through' scenario is consistent with GBP/USD trading around current levels into year-end," says ING's Patel.

Analyst Elsa Lignos with RBC Capital Markets sees three possible outcomes:

(1) one or more resignations by hard Brexiteers (GBP-negative at Monday open as leadership challenge becomes more likely, or near certain with multiple resignations)

(2) a thrashed out document with some kind of tenuous agreement (likely to be kneejerk GBP-positive, though only until it gets rejected by the EU when published next week) and

(3) another stall and extension to talks (that hasn’t affected GBP so far but with less than nine months to go, time is really running out).

It looks to us that with sentiment towards Sterling and the whole Brexit debate being so resolutely dour, the upside potential to any developments deemed positive by the market would be greater than the downside risks posed by any market-unfriendly outcome.

"We can’t recall a period when the sentiment and news flow has been so consistently negative," says Derek Halpenny, who is European Head of Global Markets Research at MUFG.

When sentiment is extreme, as could be argued of the negative sentiment towards Sterling right now, the prospect for a rebalancing grows.

Halpenny says July will bring the possibility of some increased clarity which should benefit Sterling. "Our sense here is that a lot of bad news is now in the price."

"With pessimism so high currently, the Pound could easily get a lift from the prospect of the UK government providing details on its negotiation stance and how it plans to resolve the Irish border issue," says Halpenny.

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But May will know a strategy that sees her dilute red lines offers her a good risk/reward outcome as the hard-Brexit contingent lack the parliamentary support for their vision of Brexit to pushed through, while they also fear bringing down May will open the door to another general election, one that the Labour Party would win.

Indeed with elements within Labour pushing for a "people's vote" second referendum on any Brexit deal, the pressure only rises on moderate Conservatives to back May's approach.

"If May does succeed in convincing cabinet Brexiters like Gove and Johnson to follow her path, the market should reward GBP by reducing, on the margin, its political risk premium and focus instead on the possibility of an August BoE rate hike, leaving room for EUR/GBP to again drop to levels around 0.8750," says Shahab Jalinoos, a foreign exchange strategist at Credit Suisse.

A EUR/GBP exchange rate of 0.8750 gives a GBP/EUR exchange rate of 1.1428 representing a decent 100 pip advance on the levels seen over recent days. Hardly inspiring, but evidence of a firming support level growing underneath the Pound.

However, we have reported this week that analysts at Pantheon Macroeconomics believe GBP/EUR could go towards 1.27 and GBP/USD to 1.40 on any soft Brexit. 

"If the Prime Minister does steer towards a ‘soft’ Brexit – one that keeps the UK in the goods single market and mirrors the current customs union setup – then we could see a chunky move higher in GBP given that the BoE are in tightening mode. In our estimates, this benign scenario sees GBP/USD at 1.43 by year-end. We still dare to dream here," says ING's Patel.

Credit Suisse's Jalinoos warns that if the meeting is genuinely contentious and leads to open ruptures within the government, former highs around 0.8850 are likely to act as a new base and March highs around 0.8970 would be a new target.

In Pound-to-Euro exchange rate terms, this gives us downside targets at 1.13 and 1.1150 respectively.  

"The latter scenario would also likely correspond with a test of 1.30 in GBP/USD, a key psychological level not seen since September 2017. We see more asymmetry towards a large GBP down move than recovery given that the market is already conditioned to the idea that PM May usually manages to fudge cabinet consensus her way," says Jalinoos.

The Brexiteer group intend to confront Mrs May today with a plan for her to stick to her promise to fully leave the single market and customs union and negotiate a Canada-style free-trade deal. “They believe they can shape things,” a senior aide told the Times.

An agreement modelled on the deal between Canada and the EU would mean the removal of the majority of customs duties between the UK and Europe. There would be hundreds of exceptions, however, and there would be limits on access for British companies trading in the bloc.

Crucially for Brexiteers, this type of deal would not oblige Britain to sign up to any EU rules or regulations or abide by rulings of the European Court of Justice.

The negotiations are tipped to go on until 10:30, so it might only be on Monday that we see any notable moves in Sterling owing to this matter.

A Decent Week for the Pound

Sterling has enjoyed a decent week so far, recouping losses against the Dollar and Euro, thanks largely to the better-than-forecast outcome in the PMI data series which confirms the economy is growing at a decent pace.

The Pound got a lift from a stronger-than-anticipated services PMI for June, with pound/Dollar touching a 10-day high of 1.3245 before retreating slightly while the Pound-Euro exchange rate recovered from three-month lows to trade back above 1.13 again.

A further lift was provided following a speech by the Bank of England Governor Mark Carney who signalled he is now open to raising interest rates based on evidence the economic slowdown witnessed at the start of 2018 was in fact inspired by poor weather.

Markets are betting that an August interest rate rise at the Bank of England is a a possibility, but don't expect the gains to extend on this story. Markets will wait to see the tone of the official data, out next week, before firming bets on August.

Those bets will no doubt firm further of the Prime Minister pulls a rabbit out the hat at her away day on Friday.

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