It seems it’s Christmas time again. Sure, the lights are up and across London, but isn’t the real signal it’s nearly Christmas a resurgence of Brexit risk?! For the last few years, the tensions between the UK and EU seemed to rise into Christmas. The run up to Christmas 2016 saw pressure on new PM Theresa May ahead of the General Election to declare Article 50 following the Brexit vote. 2018: the first draft of May’s Brexit withdrawal agreement is rejected in the commons. 2019: the revised Agreement is rejected once again. Christmas Eve 2020: a withdrawal agreement that was subsequently ratified by the house is agreed. Christmas may be the season to be jolly, but it also seems it’s the season to have a jolly good ruckus with the EU!
2021 is proving to be all too familiar. Recent speculation about the UK giving notice to the EU on its trade agreement were centre stage a few weeks ago. In early November, the triggering of Article 16 of the Northern Ireland agreement seemed relatively and increasingly inevitable. However, there remained insufficient clarity surrounding what elements, if any, the UK government will be forced to suspend and, in turn, how the EU would retaliate against the UK for giving notice on a key and controversial element of the new trading relationship. The impact and retaliation will be determined by even as minute a detail as how Westminster might go about the declaration and whether it adhered to the suspension protocol laid out within the agreement.
These risks have been around for several weeks and even months now. And despite a devaluation in cable (GBPUSD), which has largely been down to idiosyncratic dynamics within USD spurred by accelerating inflation, the fair value of GBP has been relatively consistent. Market positioning has shown a serious deterioration in GBP sentiment but it is commonplace these days for positioning data in the Pound to be volatile. With a net open interest of -15% according to positions declared to the CFTC as of 16/11/2021, there has clearly been a lot of negative positioning in GBP versus USD. However, with GBPEUR testing 18-month highs in recent trading sessions, we can say that the market has largely discounted Brexit’s risks in a pair well-known to reflect UK-EU sentiment.
In November, fair-value measures based upon purchasing-power-parity showed only a 1% risk premium built up in GBPEUR. This pales into insignificance when compared with the likes of 5% priced into the pair in 2019 and 2020. This could of course be put down to market complacency. However, so far, risk sentiment has remained tolerant with the UK’s capacity for monetary normalisation and potentially impending rate hikes taking far greater importance to GBP valuations.
Discussion and Analysis by Charles Porter