Pound Destined Higher as Road to Brexit is Clearer than Many Argue Nomura

Theresa May and the Pound

Image © Lee Goddard / Number 10 Downing Street

Pound Sterling is forecast to hit 1.50 against the Dollar and edge higher against the Euro over coming months argue analysts at Nomura who believe Brexit talks will go more smoothly than many in the market expect. 

The Pound has risen strongly following the news that the European Parliament wants a more flexible approach to talks with the UK than that currently being adopted by official EU negotiators.

Any softening of the stance adopted by Brussels would be seen as making it more likely a transition deal will be agreed soon, and economic interests will precede political interests in negotiations.

The Pound-to-Euro exchange rate rose from the mid 1.12s to the mid 1.13s after the news as markets bet the likelihood of a disruptive 'cliff-edge' default to World Trade Organisation trading rules with no special trade deal even less likely.  

Analysts at global investment bank Nomura reckon Brexit talks are likely go more smoothly than many in the market expect; and this implies the potential for a more stable and potentially stronger Pound.

Analyst Jordon Rochester - based in the bank's London office - argues a transition deal will be successfully agreed at the EU summit in March between 22nd and 23rd.

"Our further view is that the transition agreement will come by the end of March as a base case. Again, we would argue that relatively little of substance really needs to be agreed at this stage. One helpful facet is the EU’s position on this is so clear and simple: a transition deal entails status quo without institutional representation," he says.

Standing in the way of a transitional deal are those members of Theresa May's governing Conservative Party who want as clean a break from Europe as possible on brexit day in March 2019; this week has seen a group of 62 Conservative MPs write to May to demand the UK must have full control over laws after Brexit and must not become a "rule taker".

Were May to accept the demands and negotiate accordingly, the prospect of a transitional Brexit period is greatly diminished as it is highly unlikely the EU will accept significant restrictions from the UK in exchange for access to the single market.

Rochester however believes that, on balance, this group of politicians are likely to come round to May's position, seeing transitional Brexit conditions as a small price to pay for their eventual long-term goal of independence. 

The rules the UK will be forced to accept without any say are, in fact rather innocuous, and are unlikely to cause sufficient ill will to prevent even hardline Brexiteers from submitting.

"For those in the Brexit camp, common sense should see these multi-generational upsides as worth a year or two extra of odd regulations and unfettered immigration. We think the only true red line of the Brexiteers will be that the transition is strictly time-limited," says Nomura's head of global FX strategy Jordan Rochester.

Of course the agreement of a transition deal at the March 22-23 summit would lead to significant further upside for Sterling as the main factor keeping the currency so weak compared to its longer-term averages is Brexit uncertainty, especially in the event of an overnight reversion to expensive WTO trade tariffs, and an agreement sealing a transition period would provide confidence that a cliff-edge would be averted.

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May to Smooth the Way

Theresa May is expected to play a key role in setting the 'mood music' for the March summit, and traders seeking indications of the likelihood of success should monitor her language in the run-up to the summit.

Her conciliatory Florence speech set the scene for much smoother talks between Davis and Barnier in December and Nomura speculates that she will have a similarly influential impact on the Brussels summit.

Analysts will probably be closely watching what she says between now and then to gauge the backdrop to negotiations.

Tailored Deal Not a Problem

The commonly held view that the European Union will be resistant to allowing the UK a bespoke trade deal is not credible, according to Rochester.

Given the size, status, importance and geographical proximity of the UK, in fact, the opposite is true.

After all, Norway, Switzerland, Turkey and Ukraine all have their own bespoke deals with the EU, so why shouldn't the UK?

"The idea that the world’s seventh largest economy, an ex-member and a country that will still have strong institutional, economic and geographic ties to the EU should not get a bespoke deal is not reasonable, in our view. Already the likes of Emmanuel Macron and Leo Varadkar talk about a ‘special’ deal for the UK and even Barnier back-tracking on his assertions of no bespoke deal. The market does not seem to recognise this," says Rochester.

The more the market comes to realise a deal is likely, the greater the upside for the Pound as Brexit risk premia unwind, as it will represent a further nail in the coffin of worst-case-scenario Brexit no-deal, cliff-edge to WTO outcome.

In relation to the time it will take to carve out a bespoke deal for the UK, Nomura's Rochester is also quite optimistic, saying that he expects a deal to be agreed by 2021.

It is not likely a bespoke trade deal will take years to agree, as some argue, based on a comparison with the agreement with Canada which took seven years and had no services element.

"The Canadian trade deal was for two economic areas with varying regulatory frameworks, searching for areas where it could somehow compromise and come together. In the case of the UK it will start with an identical regulatory framework and then the two sides need to work out where any divergence should take place. We would argue that this is much easier. So our base case that a trade deal can be in place by the end of 2021 (ahead of the next UK election) seems a much more sensible base case than the concern of decades of WTO rules," says Rochester.

Political Woes and Foes

Whereas previously concerns about the integrity of the European Union (EU) encouraged the EU to adopt a harder line in negotiations with the UK - in order to make an example of the UK that other nations would not want to follow - politics is now less of a threat, especially since pro-European Macron's victory over Jean Marie Le Pen, which in hindsight provided something of a 'Waterloo' moment for Europe politically. 

The risk that far-right nationalism is overrunning Europe and threatening the integrity of the union has reduced significantly - nor does Nomura see a threat emanating from the Italian elections of the German coalition negotiations.

From the perspective of the UK and its deal with Europe, the best backdrop would be for a Macron and Merkel led Europe moving towards greater integration - and this seems, according to Nomura - like a not unlikely eventuality.

The economic backdrop is also conducive to the establishment of a bespoke trade deal.

The Eurozone economy is growing strongly after a period of stagnation and this is also a good backdrop for agreeing a deal with the UK.

The strengthening economy seems to have renewed faith in the Eurozone as an economic entity and barometers of sentiment appear to support the integrated European model more than they did before when the forces of nationalism threatened.

"It isn’t just down to the elites either: the Eurobarometer series shows a growing pro-European sentiment right across the continent (quite ironically, including the UK). This started in 2015 and is likely down to better economic performance since then, but the point is Brexit did not put a dent in it, and we think it may have even helped it," says Nomura.

Indeed against this more 'secure' backdrop, the EU can afford to be more generous in negotiations with the Uk, further improving the outlook for Brexit endgame negotiations - and for Sterling as well.


Forecasts for the Pound

Nomura are forecasting the Pound-to-Euro exchange rate to ultimately remain in touching distance of 2017-2018 ranges with a peak being seen at 1.16 - which should be achieved in the mid-year period. 

Year-end forecasts see the exchange rate back down to 1.1230 - which is more or less where we see the exchange rate at this time.

The Pound-to-Dollar exchange rate is meanwhile forecast at 1.43 in mid-year and 1.48 by year-end. Early 2019 sees the pair back up to 1.50.

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