No Brexit could support sterling

In January 2018, we wrote that focusing on the Irish border risked a “political crisis as well as a broad range of possible outcomes”, which included “a chaotic ‘no deal’ Brexit, a second referendum, and/or a General Election and change of government”. To our minds, it was relatively easy to see our way into the current political crisis; it is not so easy to see a way out.

Prime Minister Theresa May saw her government receive an unprecedented Parliamentary defeat of 230 votes (202-432) over the negotiated exit deal with the EU. While a loss had been widely expected, few expected the scale of the defeat that included 118 Tory rebels and the Democratic Unionist Party (DUP). The Labour Party followed up by tabling a vote of no confidence in the government. This vote will be held tonight at 7pm. If successful, the government would have 14 days to present a new form (new leader/cabinet/coalition) that could win a confidence motion, otherwise the country would prepare for a new General Election. At this stage, we think it is a very different prospect to lose the Brexit vote and to (risk) conceding control of the process to the opposition. We do not believe that Labour currently offers anything to any of the Tory’s warring factions to convince them to follow a vote of no confidence and so we expect May to survive this vote.

The government must now present ‘plan B’ on Monday. Given the government’s laboured efforts to produce plan A, we sincerely doubt it has a plan B. PM May promised to listen to Parliament and is set to hold discussions with senior Parliamentarians. However, it is not confirmed whether she is to convene with the Labour leadership. Moreover, there is ongoing talk that she remains committed to an independent trade policy, which effectively rules out many of the options that Parliament is said to consider. Nevertheless, after the government presents its new plan, Parliament will be able to offer (non-legally binding) amendments. This gives Parliament the chance to direct policy from this point. Assuming, PM May wins tonight’s confidence vote, this may be the high-water mark of extremism. Parliament may be able to work together to form a more politically centrist outcome (not swayed by extreme ‘no deal’ Brexiteers, nor Labour leader Jeremy Corbyn). Such an outcome could lead to a softer Brexit, along the lines of a pseudo-Norway arrangement or Customs Union, or even a second referendum. Parliament looks prepared to avoid a ‘no deal’ Brexit. However, at this stage Parliament appears a diverse group, with no majority view for one outcome. We expect the coming weeks and months to look like a US primary race: several contenders will start the field, but as different contenders gain or lose momentum they will drop out until a majority supported candidate is left. Yet there is not a clear process for this evolution to take place. We suspect it will require longer than the 10-weeks left until 29 March 2019, suggesting to us that a delay to the Brexit process looks likely from here. This looks likely to begin with an application to extend Article 50, which the EU look likely to approve only until end-June due to the timing of Parliamentary Elections.

However, the risks of the UK revoking Article 50 and a longer delay are growing. Moreover, recent history suggests that such a process can still deliver unpopular and divisive outcomes. To that end, we note that a “Norway option”, that effectively replicates EU membership, without involvement in the legislation, appears as far away from Vote Leave’s “Take Back Control” as can be thought.

Nevertheless, financial markets took the result in their stride. Despite volatility, which saw sterling drop over 1% intra-day, sterling closed the session unchanged against the US dollar and up 0.5% against the euro. Indeed, the perception of a receding chance of “no deal” has provided support to sterling in recent days. Gilt yields followed a similar pattern, while 2-year and 10-year yields dipped by 3bps and 4bps respectively across the course of yesterdays, yields rose back to 0.82% and 1.30% this morning – in line with the previous day’s open. Equities have started the day -0.1%. This stability is likely to continue if PM May wins the confidence vote tonight, with markets braced for an extended period of political uncertainty, but hopeful that a worst-case scenario will be avoided. However, a loss of tonight’s confidence vote would likely see a material shift in this outlook, and we would expect sterling and gilts to weaken on the heightened political uncertainty.