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GBP leap on unwind of no deal hedges now vulnerable to UK-EU FTA (free trade agreement) reality show

The (around) 7% climb of the GBP against the US dollar, in the week to October 18, is an example of one of those short violent moves in currency markets triggered by a sudden news-driven change in speculative or hedging strategies. 

    The resulting massive one-way demand, for the given currency, overwhelms the influence of investors who base their evaluations on long-term assessments which have hardly changed or even moved in the opposite direction during the stampede.  Many such investors, before they act to take advantage of the probable overshoot, need to gain confidence that the stampede is at an end, rather than gathering more force.

      In the case of the pound, the trigger to a massive change in trader and hedging positions was the news last week of UK PM Johnson’s capitulation to the EU in agreeing to an onerous withdrawal deal essentially on offer at any point since 2016. 

      Ex-PM Theresa May, though, was not ready to ditch its Northern Irish unionist allies and negotiate this present (Johnson) version of a bad deal (preferring the ill-fated “backstop”) which would have meant the fall of her government.

       By contrast, the Johnson government has broken with the Unionists, on the basis that a General Election is imminent and that meanwhile it would get enough dissident support from Labour party members of parliament to pass its deal. 

 how long a sigh of relief?

     The abandoning by the UK government of its Unionist allies to the demands of Dublin (as backed by Paris and Berlin) got all the media attention as the enabling step, but that was just one part of the total story of surrender.  The other chapters were already a part of the doomed May deals.

     Simultaneous with the total capitulation of the Johnson government to the EU, as regards the Withdrawal Agreement (no pairing back of vast “reparation demands”, no guarantees about a free trade deal to follow only a vague political declaration with no legal force, up front permanent residence status to recent immigrants from EU), the probability of a “no deal Brexit”, aired by the Johnson government as an essential component of its short-lived apparent non-capitulation strategy, shrunk to near zero.

      Evidently in the marketplace, there had been huge hedging of a “no deal Brexit”, on the assumption that all the dislocation related to this would sink the pound. 

      Yes, it is plausible that a “no deal” outcome (a misnomer because in fact there would be a whole series of mini-deals after Brexit-day) would have been best for UK and European prosperity, going forward into the medium or long-term. Walking away from the table would eventually bring a softening in the EU stance, whilst meanwhile allowing the UK to get on with its new global agenda including free trade deals, starting with the US.

       That view, however, was certainly not endorsed by hedgers and short-term traders in the approach to October 31.  

        Can the pound’s gains under the influence of these short-term considerations as described above (the sudden fading away of “no deal”) be sustained or should we expect longer term negative scenarios (and some realization of these) to drag the pound down, potentially far below early September levels?

 

The view here remains pessimistic on the pound.

       Yes, there is a scenario where PM Johnson gets Parliament to approve the calling of a General Election at some point in the next few weeks or even into early next year. The Conservatives (without the Unionists) may well win a majority at that election, not least due to the unpopularity of the leader of the Labour Party. 

      That political outcome is far from certain.  After Brexit Day, “Remainers” may return to Labour from Liberals; and the Brexit party may gain traditional conservative voters now dismayed by the Johnson EU withdrawal agreement and distrustful of further capitulation in concluding a free trade deal.  Moreover, many voters may seek to “punish” the Conservatives for their total ineptness in devising and executing a Brexit strategy since 2016. 

 

Back to no-deal exit by end 2020?

        Yes, with a majority, re-elected PM Johnson may at last harden up the negotiations with the EU with respect to the FTA (free trade agreement) deal. 

       Specifically, he would threaten to end the transitional period on 31.12.20 (according to the withdrawal agreement a renewal has to be agreed by mid-year and subject to huge potential revenue demands from the EU) even if little real progress has been made to an acceptable deal by that point.  That would mean a no trade deal exit.       

      No one should be optimistic about anything like a good FTA (free trade agreement) deal for the UK emerging next year, even with the UK government belatedly giving up on soft ball tactics in favour of a hard ball approach.  

      Yes, a good deal might have been obtained in 2017 or 2018, if the May government had walked away from the table, set a near-term date for exit from the EU with or without a deal, and concluded quickly an alliance (together with an FTA) with the US, when the Republicans still had a majority in the House.  That is all now water under the bridge.

The fading away of a UK-US deal

       A US trade deal is now utterly implausible ahead of the November 2020 elections.   The impeachment proceedings and the debacle of US policy in Syria, and more broadly the Middle East situation, conveys that the Trump Administration is viewed everywhere as undependable. 

       The best prospect of the EU starting to climb down and meeting the UK half-way or quarter-way has always been predicated on a London deal with Washington.   Accordingly, if a re-elected PM Johnson walks away from the EU negotiating table next Spring or Summer, it will be into the Arctic sea; no comfort or cushion there from alternative alliances of consequence. 

       What would meeting the UK part of the way mean in present circumstances?

       Fundamentally, the FTA (free trade agreement) would have to include critically the UK’s service sector, where that economy has its comparative advantage.   Up until now, the EU has insisted that an FTA would be for goods only – the trade in which Germany has a huge surplus with the UK – whilst UK service (especially financial) exports (amongst other things, insurance, asset management) would be subject to a range of non-tariff barriers.

UK’s barren hopes of including services in EU FTA

        To get a reasonable trade deal, including services, the UK government would have to bargain hard.  The opening gambit would be “if you (the EU) insist on putting barriers in the way of our service exports, then we will put tariffs on (at WTO rates) German autos, for example (but also more broadly); and simultaneously we will open up out trade (tariff free) to imports from the US, Canada, Australia, which means your exports will now be at a competitive disadvantage in the UK” .

       That hard talk strategy would be particularly effective, in principle, in the German political scene, where the right wing (especially the FDP) has traditional roots in the Mittelstand companies, for whom the UK is a key market.   But for now, there is no evidence that Chancellor Merkel’s party, the CDU, is anywhere near making a fundamental turn to the right. 

       Rather, it has dug into the centre and been moving further towards the environmental Left, with the aim (unsuccessful so far) of winning voters away from the Greens. 

       The latter may yet be the largest party after the next Bundestag elections (which might even come early in 2020, if the SPD bolt Merkel’s coalition government next month, as some German analysts expect).  

       If this cold reality deters a re-elected Johnson government from leaving the negotiating table next summer, and instead, signing up for a further year and then another year of tribute payments to the EU to preserve the status quo (already impaired for services in the transition) then that is not grounds  for optimism on the pound or the UK economy.  

       Furthermore, there is absolutely no indication that a Johnson government will be reversing course on soft money policies, as practiced aggressively under the Cameron and May governments. 

 

Continuous postponement of breaking with status quo

        For ever postponing the UK’s exit from the status quo in Europe (legally out of the EU but in a transition agreement is no real exit) means that (meanwhile) even after the 2020 US election, independent trade deals are not feasible (the other side wants to know first what the terms are for the UK-EU trade deal or whether in future trade between the UK and EU will be on a WTO basis).  

      When the UK eventually exits the transition period (say 2022) it could be into a lop-sided FTA (as for goods only not services) for which the running costs are very high; or there may be no FTA at all, but after six years since the 2016 referendum, the UK would be back essentially to the crossroads of a “no-deal” exit in much less favourable circumstances. 

      Note, after the Withdrawal Agreement is ratified, the UK has much less negotiating power than in previous years.  

      This reduction is due to first, the UK’s shrunken scope in terms of domestic political reality to offer big budget contributions over several years (UK voters may have accepted this for a few years following the referendum but not into the 2020s); and second, to the freedom to withhold permanent residence status from recent migrants from the EU (that status is granted as part of the Withdrawal Agreement).

       In short, the idea that the UK is heading towards an FTA deal with Europe modelled on that between Canada and Europe – and thereafter a prosperous and mutually beneficial UK/Europe future, is largely pie in the sky.

       Note, in any case that the Canada-EU deal barely includes services trade – hardly a relevant prototype for the UK economy, with its comparative advantage in services. 

From Canada’s EU deal to PM Trudeau’s election loss

        Finally, a footnote on Canada.   PM Trudeau signed that country’s free trade deal with the EU in October 2016.  That was early on in his Administration when still full of promise. 

         This week, Justin Trudeau and his Liberal Party suffered a serious setback in the Canadian General Election, albeit winning enough seats to form a minority government, which has a good prospect of making deals with the NDP (left of the liberals) or the Quebec nationalists who gained from a late inflamed dialogue about the banning of religious symbols in various public services 

      The Conservative party, which won barely the popular vote, had to cope with the practical erosion of one traditional selling point – being able to get on well with the US Administration.  That is no longer an asset, given that no one can safely consider themselves in a special alliance with the US – as revealed most starkly by US-Turkey-Kurds-Russia history in the Middle East or a few weeks earlier when Saudi came under attack from Iran. 

 

Outlook for the Canadian dollar

       In principle, one might have imagined that a Liberal Government in Ottawa, now in minority situation, would be a trigger to some weakness in the Canadian dollar.   But most likely this outcome was already baked into the cake before election day. 

        Much more important for the course of the Canadian dollar has been the general “risk-on” mood in global markets, as generated by the stampede in the wake of the China-US “tariff truce” and related agreements.   The Canadian dollar behaves as a “risk-on” asset in the absence of new information or a shift in the market’s analysis of existing information that triggers a change in its valuation against other currencies.   

       Moreover, there is a widespread perception that the Canadian economy is strong and that the Bank of Canada will not follow any rate cut from the Fed in coming weeks (or months), meaning that Canadian money market rates could actually edge above US rates.   The Canadian dollar becomes even more than now a carry trade destination for income-famine investors, especially in Europe.

       That optimistic take, on Canada and the Canadian dollar, is unlikely to endure.  Even now, year-on-year economic growth in Canada is barely 1.4% year-on-year, as against population growth of 1.5%.  As economic commentator David Rosenberg points out, productivity in Canada is on a flat trend. 

        The only growth (at around 3% p.a.) is in the government sector, cannabis, and multi-unit construction (highly speculative); the rest of the economy is stagnant.  The basic balance of payments deficit (current account balance and net direct investments) is at around 3.5% of GDP.  Further global economic slowdown, especially in China and Asia, would weigh further on key export sectors (especially energy) in Canada, where the key auto sector is already in recession.   here is virtually no chance that on US Election Day a ray of sun will appear, in an otherwise bleak monetary landscape.

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Executive Summary

The seven per cent jump of the pound in a few days, based on a sudden violent change in hedging positions, is not without precedent. 

The key question is whether fundamental forces have changed in a way likely to ratify that movement.   In the case of the pound today, the answer here is negative.  

The capitulation to EU demands, to secure a Withdrawal Agreement and avoid a “no deal exit”, leaves a perilous path ahead both economically and politically for the UK.

Optimism that the UK can secure a Canada-style FTA  (free trade agreement) has no firm basis.  An FTA deal without services for the UK economy is arguably worse than no deal. 

The fading away of any prospect of a US deal before 2021 with UK is a serious blow to Brexit.    

ALERT: Canadian dollar, like the British pound, has been subject to stampede, albeit smaller. Read on!