Signs of Progress on Irish Border Bodes for Further Gains by the Pound

Ireland's Prime Minister Leo Varadkar backs a Brexit deal within weeks. Image © European Council, Reproduced Under CC Licensing

- Reports say EU is compromising on Irish border

- This more than anything else could help achieve a detente

- 'No deal' Brexit an increasingly toxic brand

- Pound Sterling could see surge from 'no-deal' undervaluation

A 'no deal' Brexit scenario is looking increasingly improbable amidst fresh signs the EU is relaxing its negotiation stance on the Irish border and the 'no deal' Brexit brand grows increasingly toxic.

The tangible progress means the delivery of a Withdrawal Agreement by November at the latest is probable which in turn has bullish implications for Pound Sterling as it will remove a hefty amount of risk supressing the currency we believe.

An article in the Times at the start of the week reports that diplomats in Brussels are relaxing their demands for a frictionless Irish border and are now willing to consider the UK government's proposal of a 'non-physical' high-tech border solution instead.

If the reports are true, we are witnessing a major win for May who has long-insisted the Irish border question could be solved by technology.

Indeed, even Brexiteers in her own party who are opposed to May's so-called Chequers Plan have advocated the use of technology suggesting this outcome is a win-win-win.

The question of the Irish border has been a major sticking point in Brexit negotiations and without a consensus on the matter the prospect of a disruptive 'no deal' Brexit scenario becomes likely.

Both the EU and UK wish to keep the border open regardless of the outcome of Brexit.

But, the sticking point appears to be the EU's insistence that in a 'no-deal' scenario the Irish border would remain open and checks on goods take place within the UK, creating a border within the UK.

This is the so-called Irish border 'backstop' plan.  

This plan has enraged many Brexiteers and Ulster unionists alike, who Theresa May relies on as majority-providing allies in Parliament.

They maintain the UK's integrity must be upheld after Brexit, and that means the border between the UK and EU remains between Northern Ireland and the Republic of Ireland.

The high-tech border proposed by Theresa May's government would involve the use of bar codes on shipping containers under “trusted-trader” schemes administered by registered companies.

This would remove the need for new border infrastructure. The bar codes could simply be scanned at border checkpoints without the need for lengthy delays.

It is the same procedure that is used between mainland Spain and the Canary Islands and works perfectly well to maintain a friction-less border there so should work equally as well in he case of Ireland

If the Times story is right the EU may be about to make a pivotal compromise which could see the chances of a trade deal greatly increase, and if that happens Sterling should make back some of its post-referendum losses.

In further signs of progress, the Financial Times reports the EU is considering allowing British officials, rather than the bloc’s inspectors, to check goods heading to Northern Ireland from mainland Britain.

It follows comments from Chief EU Brexit negotiator Michel Barnier in which he expressed a desire to “de-dramatize” the Irish border issue.

"The report is a further encouraging sign that the EU and UK are moving closer to finalising the withdrawal agreement," says Lee Hardman, currency analyst with MUFG in London.

The Pound is considered severely undervalued based on economic fundamentals purely because of the risk of a 'no-deal' Brexit. Should that possibility be removed, Sterling would make back the circa 10% difference almost overnight.

"Hard Brexiteers could back the government’s Brexit legislation to secure an exit from the EU, and then turn their attention to modifying plans for the future trading relationship beyond the Article 50 period. Overall, the developments continue to support our view that a more disorderly 'no deal' outcome remains unlikely. It leaves scope for the Pound to rebound if a 'no deal' outcome is avoided," says Hardman.

Ireland's Prime Minister Leo Varadkar has meanwhile suggested that a deal between the EU and UK can be done within weeks, suggesting a solution is near.

Today, the European Union's chief negotiator Michel Barnier has a busy schedule: he is to meet the Irish Deputy Prime Minister and Minister for Foreign Affairs and Trade, Simon Coveney.

We might get some confirmation today that the EU is indeed shifting on the Irish border question. If confirmed, then the prospect of the Withdrawal Agreement being concluded before year-end is certainly likely and could provide further support for Sterling.

Barnier also attends the General Affairs Council of the European Union to discuss Brexit.

We will be wary of any headlines from the event, noting a press conference scheduled for 16:30 B.S.T. and 18:30 B.S.T.

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'No Deal' Becoming Increasingly Toxic Brand

The Pound has recovered over recent weeks as the prospect of a 'no deal' Brexit diminishes; we note that the 'no deal' brand has become quite toxic and there appears little appetite for such an outcome in any corner.

The International Monetary Fund (IMF) this week warn of the negative economic consequences to the British economy of not reaching a Brexit deal.

According to Christine Lagarde, the IMF's director, all bar one will cost the UK economy in terms of growth and jobs.

Expressing the IMF’s growing concern at the possibility of an acrimonious divorce next March, Lagarde said: "if that happened there would be dire consequences. It would inevitably have consequences in terms of reduced growth, an increase in the deficit and a depreciation of the currency. In relatively short order it would mean a reduction in the size of the economy."

Speaking at a press conference at the UK Treasury, Lagarde warned the argument forwarded by Brexiteers that the UK would thrive if it left the EU without a deal and then traded on World Trade Organization terms.

"Our projections assume a timely agreement with the EU on a broad free trade pact and a relatively smooth Brexit process after that. A more disruptive departure will have a much worse outcome. Let me be clear: compared with today’s smooth single market, all the likely Brexit scenarios will have costs for the UK economy, and to a lesser extent for the EU, as well. The larger the impediments to trade in the new relationship, the costlier it will be. This should be obvious, but it seems that sometimes it is not," says Lagarde.

Meanwhile, corporate Britain is also upping the ante on the UK to reach a deal.

The boss of Land Rover and Jaguar recently said that in a worst case scenario the company would have to move manufacturing of its cars out of the UK.

A 'no deal' is simply becoming an idea that can only be sold to a minority of Brexit purists.

A Floor Under the Pound

The various clues suggest the chances of a 'no-deal' are declining yet further.

The evidence supports a floor in the Pound or perhaps even a move higher.  

"For GBP, not much else matters besides Brexit. Our framework consists of reducing the Brexit premium priced into both spot and options, suggesting further room to price out the tail risk scenarios over the coming weeks and months," says Richard Kelly, Head of Global Strategy with TD Securities.

Markets will be watching the Wednesday and Thursday informal meeting of the European Council for developments regarding Brexit at the national level, Kelly believes the summit, to be held in Salzburg, should cement some of the upbeat headlines over the past few weeks.

"It is true that political headlines tend to generate more for more two-sided (than one-sided) risk, but with lots of bad news priced in, we expect cable to have another go at the 1.32 level in the immediate future," says Kelly.

The Thursday session will discuss Brexit, so we are wary of headlines at this point.

Analysts at Nordea Markets say their base-case scenario is a Canada “plus” deal to be delivered - the kind desired by Brexiteers.

The striking of such a deal should allow the Bank of England to deliver the next rate hike in Q4 2019 followed by another one in Q4 2020.

Nordea analyst Andreas Steno Larsen forecasts that under the Canada scenario the Pound-to-Euro exchange rate will rise back to 1.17 eventually and that under a "Norway style" European Economic Area deal the exchange rate could go as far as 1.2195.

However, he also warns about the likely consequences for Sterling if the U.K. leaves the EU without any deal at all.

"In case of a “no-deal” we would expect the fair value of EUR/GBP to move from levels around 0.85 to around 0.93," Larsen writes. "The risk of an even larger initial sell-off in GBP is profound, as markets tend to overshoot fair-values in times of stress. So levels of 0.95-0.98 in EUR/GBP are surely within reach as the first reaction, but we would consider such a massive GBP sell-off overstated in a longer perspective."

A EUR/GBP exchange rate of 0.93 translates into a Pound-to-Euro rate of 1.0752 while a EUR/GBP rate of 0.98 would see Sterling trade all the way down to 1.0204.

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Lock in Sterling's September recovery: Get up to 5% more foreign exchange for international payments by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here