Morning Brief – Overreaction

Overreaction
 

Yesterday saw the implied probabilities of a no deal exit from the European Union rise within betting and foreign exchange markets. The source of the threat stemmed from Boris’ approved request to Her Majesty to prorogue Parliament. Translation: make lawmakers come back to work later than planned to prevent legislation legally blocking a no-deal exit from the EU from being created and passed. 

A flight to safety saw money rush out of the Pound and into more defensive assets. Treasury yields in the UK fell once again as perceived economic risks mounted, increasing the market value of holding low reward but heavily defended money. The Pound lost around 0.7% at worst on a trade weighted basis and up to 1% against a rising US Dollar. Overreaction? No! Not even a little bit. 

The overreaction came on Tuesday. Pro-remain MPs, some 200 strong, have signed a promise to sit and contest the government on any course that would target a no-deal exit on 31st October. Upon the suggestion of either passing legislation to demand the government to seek an extension from the EU or setting up a rival parliament to undermine the government, Sterling rose some 0.5%. Overreaction? Yes! 

If you look in terms of pure value the Pound’s reaction over the two days should tell us that 200 MPs signing a letter is half as important as granted permission from the Sovereign to forbid Parliament from stopping a no-deal. Let’s put that impact into numbers to quantify the impact. There’s about 2.9 trillion quid in the UK system, that’s the amount of money in existence using a fairly middle of the road measure of the breadth of money called “M3”. So, Tuesday’s news of opposition to a no-deal added about 14.5 billion to the value of that money and yesterday’s no-deal development, even certainty as some yesterday said, added 29 billion onto that value. 

The relative impact in markets of both events is staggering given the fact that 200 MPs is less than even the Labour Party alone have in the House of Commons. To set up a rival Parliament 2/3s of MPs would have to defy order, equal to 434 of them! So what Tuesday really showed is that Parliament has less than 50% of the number of people required to do anything about Boris’ no-deal push! Wednesday delivered something real, something certain, that will, negotiations and backstop permitting, force the UK out of the Union on Halloween with WTO standards and an alien status with respect to the Union. Yesterday may well have been worth losing 29 billion from the value of UK money but Tuesday isn’t worth a penny on that!

So why?! Well, market reporting and positioning data shows us that for every market participant long of GBP (betting that it will increase in value), there are 3 others that think it will go down and have put their money on it. Think about it: Every time the price goes down and your bet gains in value why would you do anything? You wouldn’t! You take the appreciation and have no incentive to change your position in the market so there’s limited market action and therefore little price action. However, when things start to look up and you’re going to pay for that improvement hand over fist you do something about it: you get the hell out! You buy back the instrument you’ve bet will do down and thereby add to the aggregate demand for Sterling to protect yourself from losing any profit gained and potential losses. The lesson to take away is that good news will sell from now on – it has the potential, given market positioning, to rally the Pound well above its post-Brexit range. Bad news, no-deal rumours and developments will only marginally force Sterling to sell off. Watch out then for any change in tone from Johnson not surrounding the prorogation but in Brussels. Amidst the whirlwind Johnson is creating we’ve missed that he’s only after a removal of the backstop from May’s withdrawal agreement that had the support of the European Council (admittedly not Parliament). Boris’ government is happy to the withdrawal bill (which for the record is far less than the value the Pound lost versus its peers overall yesterday) and it’s okay with the 599 pages of the document besides that. Watch Brussels, watch Ireland and watch Downing Street for any sign the backstop could go because the Pound will fly. 

Discussion and Analysis by Charles Porter

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