Cutting off your nose to spite your face – Brexit

Tue 31 Oct 2017

Brexit Discussion and Analysis by Charles Porter:


Italian Prosecco, German automobiles and French wine. While bargaining chips are poured out only to be raked off the table, Brexit is coming more convoluted. No deal is better than a bad deal; no matter what you make of that statement, we’re all relatively unified behind the idea that a bad deal, or a no-deal, is inferior to a good deal. Surely the same should be true for the Eurozone, however, markets appear to be unsure about how to deal with this phenomenon.


Let’s not forget, after all, Brexit hurt the European Union and the Eurozone too. Undermining the longevity and confidence within the European project, the Brexit vote saw the Euro slide by 3.5% against the US Dollar.


Of course, the slide was far less magnificent than the decline of the British Pound. Losing nearly 12% of its purchasing power against the US Dollar, the Pound sank towards long-term lows across the board. The snap loss against the Euro was moderated by the implication of the Europe itself within the phenomenon of Brexit.


Despite popular misconception, Brexit is not idiosyncratic to the UK – far from it. The insulation of the trading value of the Pound Sterling-Euro cross was in the order of 30%. Whilst not directly attributable to the relative burden of a Brexit upon both parties, the inextricable relationship of mutual harm or mutual support should be inevitable.


In other words, it appears inconceivable that Brexit is a zero-sum game; surely, what one party ‘gains’ through progress and certainty is not a value taken directly from the other party. Admittedly if Brexit is, as I suggest, a positive-sum game then any advancement in negotiations can, and must, still have a larger effect within the UK than Europe. This is because there is more uncertainty priced into Sterling markets.


Turning to events following the referendum itself, we see that markets are not pricing Brexit negotiations as a positive-sum game. This is apparent because Brexit related movements within the Euro and Pound have been inverse, even when they ought to be mutual. Despite occasional ridicule of Mr. Johnson, prosecco, wine and cars are negotiating chips because mutual trade is unequivocally important to both sides of the Channel.


Progress in first round Brexit negotiations facilitates consideration of the second round concerning the future relationship of the UK and the EU. If the Florence speech was, as European officials have agreed, such a success then the Euro and the Pound ought to have both received a tailwind.


The Florence speech contained partial assurances and advancements on citizens’ rights, Northern Ireland, and a sheepish €20+bn guarantee.


It seems implausible that these guarantees do not considerably reduce the uncertainty within the Eurozone economy surrounding a no deal. The Prime Minister’s concessions to the European Union prevent funding and budgetary crises in the absence of Macron’s desire towards a budgetary union. Moreover, they weigh against the likelihood of public crises within the European Union that have marred it before (cf. migration crisis).


Therefore, the realisation of a bearish Euro and bullish Sterling following episodes of Brexit progress is remarkable. It is understandable that the Sterling-Euro currency pair would be bullish – in favour of the Pound. However, for the Euro to consistently weaken against, for example, the US Dollar and major international currencies, is astounding. Despite implausibility, this is what we saw following PM Theresa May’s Florence speech.


The same story is true following the recent and highly progressive EU Council meeting that concluded on 20th October. Donald Tusk, President of the European Council, announced that the Council has “agreed to start internal preparatory discussions” regarding the future relationship. Lending weight once again to the Florence speech, President Tusk praised the speech.


Once again, however, Brexit progress was met by considerable and sustained Sterling strength amidst Euro weakness. Cable, the US Dollar-Pound Sterling exchange rate, appreciated throughout the day and into the next week with the very same trends being reflected in the value of the Pound with respect to the Euro. In contrast, the Euro diverges strongly, trending downwards admittedly in a sign of Dollar strength, but also unmistakable Euro weakness.


So why?


Is the market incorrectly pricing the value of good Brexit news to the Euro? Or is the probability of an immense divorce bill, free trade and European cohesion so heavily priced into the exchange rate that Brexit progress simply doesn’t matter? Or, however unlikely, is no deal genuinely better than any deal for Europe?!


Well, it’s hard to say. Certainly, the latter two are not base cases for the Euro. Its strength has been derived from the re-emergence of economic growth and the hope of future inflation. What is certain, is that price action surrounding Brexit events should be watched closely.


Ultimately, the European Union is void of a legal binding. Whilst Article 50 seems vague and impenetrable, the clause does provide the Lisbon treaty with the capacity to secede from the Union. Therefore, in order to achieve  acceptable cohesion within Eurozone, which is the principal source of value for the Euro, the benefits of membership must continually remain in excess of its costs.


The quantification of costs and benefits within a diverse Union is not simple. However, it certainly spreads across more than pecuniary budgetary contributions and receipts.  With external trade deals proving popular within the Union (c.f. Canada), the future EU-British trading relationship will be important to the trade-off. Therefore, markets should price Brexit progress as mutually positive for the Pound and the Euro.


Find more Brexit analysis here.


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