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Sterling’s volatile swings so far this week — as prospects rose of a deal in the first round of the Brexit negotiations and then abated — offers some pointers to how markets could react as the UK and EU seek more substantive talks on trade in the coming months.
The pound briefly rose above $1.35 as Theresa May’s negotiations were well received by markets, capping a 10-day period during which sterling gained 2.4 per cent on the dollar. Yields on the policy-sensitive two-year gilt tipped above the 0.5 per cent base rate of interest.
News that the talks had stopped short of a deal saw sterling unwind some of those gains and selling extended on Tuesday, pulling the currency below $1.34. The yield on two-year gilts was back bvelow 0.5 per cent early on Tuesday.
The last minute disagreement over the Irish border could still derail any deal. But, the upbeat language emerging from Brussels on Monday kept investors hopeful that the first round would reach a successful conclusion. In which case, what are the implications for markets?
1. Action matters to investors a lot more than words
Brexit uncertainty has been a running sore not just for UK business but for investors. In the early post-referendum months, sterling would move on comments even from junior UK ministers and minor EU players, until the market got tired trying to interpret the implications of every cough and splutter.
While the election moved sterling this spring, Bank of England hawkishness was the main driver after the summer, pushing Brexit into the background. The pound traded sideways while negotiations took place, but began to rally when reports emerged of breakthroughs in the talks.
That could be mirrored by markets’ response if the talks progress to a transition deal and a second phase of negotiation — sterling may not move on much Brexit news until the very end of the trade talks.
2. The pound should stay becalmed . . .
A transition deal would provide not just breathing space for trade talks but certainty in the short term for business, which was becoming increasingly concerned about the risk of the UK leaving the EU without a deal.
“We were coming to a very difficult point for investment in the UK,” said Richard Benson of Millennium Global.
If a first-phase deal is reached, that threat should recede, as should the fear that companies would move jobs out of the UK. A transition deal “takes the heat off the agenda” and opens up the next phase of talks as well as potential investment opportunities for next year, Mr Benson said; as far as markets are concerned, Brexit will “leave our front pages” in the first quarter.
3 . . . and a floor may emerge for sterling
Analysts were caught in a bind — forecasting both a sharp rally and a big fall for sterling depending on the outcome of the latest talks. Now, a successful first-round deal would all but extinguish fears of another deep sterling plunge and enable analysts to focus on a more narrow question — how far can sterling rally?
“I suspect that in the absence of any political domestic developments, we may find that 90p would prove to be the upper band for euro-sterling and $1.30 the lower band for sterling-dollar,” said Simon Derrick of BNY Mellon. “But when it comes to the UK, what may feel perfectly calm can very quickly turn to dust.”
4. The political storm clouds would still hover
The UK still has a long road left to travel, even if the negotiations with the EU are set on to a firmer footing — trade talks will be torturously detailed, while Mrs May still has domestic political minefields to navigate. The fragile nature of her grip on government provides plenty of reason for investors to remain cautious.
“Even if the green light for trade negotiations is given, these are very likely to be highly complex,” said Vasileios Gkionakis, co-head of strategy research at UniCredit.
“The internal political dynamics of the UK government remain a big question mark, as there is still no agreement within the cabinet on how the future relationship with the EU should look.”
5. UK interest rates would be back on the agenda
If Brexit does take a temporary back seat for investors, they are likely to focus instead on monetary policy. Although the BoE has unwound last year’s post-referendum rate cut, it remains unclear whether this was a one-off move or the start of a conventional monetary tightening cycle.
Mark Carney, BoE governor, has been at pains in recent weeks to hint at the latter, and after an underwhelming initial reaction to the rate cut, gilt yields remain near their peaks for the year, an acknowledgment of the increased likelihood of further rate rises next year.
A swath of economic data updates this week should provide further clues. Any signs of wage growth, in particular, would increase the likelihood of further BoE action and could trigger a greater repricing of government debt.
“Current market pricing — with the next 25bp hike not fully priced until late 2018 — looks implausibly dovish,” said Ross Walker, head of European economics at NatWest Markets. “We remain unconvinced that further bank rate hikes are actually warranted by the data, but those arguments held in November 2017. The MPC has crossed the Rubicon and actually raised rates. We expect them to do so again.”