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Merkel Hints on Backstop Compromise Prompt Recovery in Sterling Exchange Rates

Tusk and Merkel

Above: File photo of Angela Merkel and Donald Tusk. Image © European Union

- Sterling recovers losses on Merkel comments

- Johnson sends official request to EU for Brexit renegotiation

- Initial reaction from Brussels is negative

Pound Sterling recovered its earlier losses on Tuesday following comments by German Chancellor Angela Merkel that suggested there might be room for movement on the vexing Northern Irish border question.

The Pound went sharper after Merkel was quoted as saying the European Union would think about practical solutions to the backstop, an agreed insurance policy for the Irish border that London wants scrapped.

Speaking in Iceland, Merkel said:

"The moment we have a practical arrangement on how to preserve the Good Friday agreement and at the same time define the borders of the (European Union's) internal market, we would not need the backstop anymore. This means we would naturally think about practical solutions. And I've always said that when one has the will to find these solutions, one can do so in a short period of time. The EU is ready to find a solution."

While there was certainly a pop in Sterling on the interpretation that the EU are open to talking about the Northern Irish border, we would suggest gains will be tempered by Merkel's comments that the Withdrawal Agreement itself stays closed.

Pound to Euro in brief spike

Above: Sterling spikes higher against the Euro on Merkel's comments

"Sterling shot higher in a brief flurry of buying panic as algos were triggered by comments from Germany’s Angela Merkel on Brexit. She said Germany would think about ‘practical solutions’ to the backstop, adding that this is a matter of the political declaration, not of the withdrawal agreement," says Neil Wilson, an analyst with Markets.com.

The currency market's reactions to Merkel's comments remind us that Sterling remains highly sensitive to political newsflow and will remain headline driven for the foreseeable future.

"In reality this is just more noise than anything else. Warm words, but the EU’s response has been clear enough. At the very most it opens just a chink of light amid all the doom and gloom for the pound. Expect more of this kind of noisy price action over the coming days and weeks," says Wilson.

Pound Sterling was earlier seen trading lower as it became clear the EU's stance towards reopening the Brexit Withdrawal Agreement has not altered, and that they will not consider dropping the Northern Ireland backstop as per a request from UK Prime Minister Boris Johnson.

European Council President Donald Tusk said on Tuesday Johnson's demands to drop the Brexit backstop came with no "realistic alternatives" and amounted to seeking a return to controls along the Irish border.

The Pound was seen lower across the board as the developments ensured market nerves remain elevated over the potential for a 'no deal' Brexit transpiring on October 31. The Pound-to-Euro exchange rate is quoted at 1.0918 the Pound-to-Dollar exchange rate at 1.2099.

Tusk was responding to a letter in which Johnson said the backstop must be removed if there were to be any chance of Parliament approving any Brexit deal, as it is perceived to compromise the sovereignty of the UK.

"The backstop is an insurance to avoid a hard border on the island of Ireland unless and until an alternative is found," Tusk said. "Those against the backstop and not proposing realistic alternatives in fact support re-establishing a border. Even if they do not admit it."

Tusk's comments follow those of the European Commission, which said the backstop is the only way of ensuring there is no hard border on the island of Ireland following Brexit.

Referring to Johnson's letter to the EU, spokeswoman Natasha Bertaud said it does not "provide a legal operational solution to prevent the return of a hard border on the island of Ireland. Our position on the backstop is well known...It is the only means identified so far by both parties to honour this commitment."

In a sign of just how poor relations are betweem the two sides, the UK followed up with their own response:

“If the Commission only wants to offer the same failed backstop that will not pass then they are essentially choosing to risk either a hard border in NI or a border in the Irish Sea. That is not what anyone wants,” reports James Crisp, Brussels Correspondent at the Telegraph.

"The likelihood of a hard‑Brexit or early General Elections are higher than a new Withdrawal Agreement over the next few weeks. In the meantime, the political uncertainty associated with a hard‑Brexit or new General Elections will continue to undermine GBP," says Elias Haddad, a foreign exchange strategist with CBA.

Johnson on Monday night officially launched a bid to renegotiate the Brexit deal when he wrote to the European Council's President Donald tusk. The focus of Johnson's request fell on the Northern Irish backstop, "I have written to the European Council President about key aspects of the UK’s approach to Brexit, problems with the “backstop” & the Government’s commitment to the Belfast (Good Friday) Agreement whether there is a deal with the EU or not," said Johnson.

Johnson says the backstop must be replaced with "alternative arrangements" designed to ensure there is no 'hard' border between the UK and Ireland.

Johnson says any alternative arrangements must be in place in time for the end of the transition period and critically, he offers to look at new “commitments” if that doesn’t prove fully possible.

Commentators suggest these commitments are in effect substitute measures that would replace the backstop to avoid a 'hard' border.

In short, he is suggesting a new kind of backstop, but one that does not lock the UK into becoming a European law-taker.

This we find significant in that he is suggesting that a solution be found that maintains the spirit of the existing backstop deal, and it is worth pointing out that both sides have yet to call time on negotiations.

Johnson says any commitments must not clash with three major objections that he lays out to the backstop: on sovereignty, the destination of the future relationship, and undermining the Northern Ireland Good Friday Agreement.

"Boris Johnson begins his Brexit renegotiation with a letter to Donald Tusk. In short, the backstop must go, completely," says Tom Newton Dunn, Political Editor at The Sun. "Boris is proposing a new backstop (but nobody will call it that) to keep the Irish border open. What does that look like? That's the million euro question... but still a significant move all the same tonight. It begins."

EU diplomats have meanwhile told the Telegraph Johnson's demand to abolish the Irish backstop is a “clear attempt” to kill off any prospect of renegotiating the Brexit deal.

Brussels 'insiders' told the newspaper that his letter leaves no “room for compromise” and is likely to be rejected.

One EU diplomat said that Johnson had failed to put forward any "realistic alternatives" to the backstop, adding that “hope and imagination” would not prevent a hard border from being erected after Brexit.

"One has the impression that any glimmer of hope is permanently nipped in the bud. Investors still don't seem to trust the British Pound, as Boris Johnson's approach has not changed at all," says Marc-André Fongern at MAF Global Forex. "Under these circumstances, I do not currently see any convincing reasons for a sustained appreciation of the currency. Unless, of course, the EU would be willing to resume negotiations with the UK."

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However, we believe the statements from the EU's most senior politicians will be key.

Johnson is due to travel to Berlin and Paris this week where he will sound out his new plans, and we believe comments by German Chancellor Angela Merkel and French President Emmanuel Macron will be important for the Pound.

Any hint that the two might be open to the suggestions would prove highly supportive of Sterling we believe. The currency is heavily sold, and any positive triggers could prompt an aggressive 'covering rally' whereby traders exit short bets and the Pound recovers higher as a result.

Much will depend on the response of Ireland, who have long been opposed to the Northern Irish backstop being dropped from the existing deal: will they maintain the deal cannot be renegotiated, or will they be open to any idea that will ensure a deal is done, will committing to keeping the border open.

We will be watching for any reaction from Taoiseach Leo Varadkar and his deputy, Simon Coveney.

Media report the release of the letter to Tusk came after a one-hour phone call in which Varadkar and Johnson clashed over the backstop, and we therefore don't see any chances of an imminent breakthrough in Anglo-Irish relations on the matter.

Of course there will be a huge dose of scepticism to the overtures by Johnson, after all the EU have long said they are simply unwilling to renegotiate, and the Northern Ireland backstop is a 'red line' they are unwilling to cross.

But, with Johnson proving committed to leaving the EU on October 31, with or without a deal, it is becoming obvious that both sides need to start shifting if they are to avoid any negative consequences associated with a 'no deal' Brexit.

We believe that as long as there is hope for a renegotiation then the attractiveness to traders betting the British Pound will fall to fresh lows is greatly diminished.

The threat of substantial upside moves in the event of a deal being snatched could therefore put a solid floor under the currency.

BannerTime to move your money? Get 3-5% more currency than your bank would offer by using the services of foreign exchange specialists at RationalFX. A specialist broker can deliver you an exchange rate closer to the real market rate, thereby saving you substantial quantities of currency. Find out more here.

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