Nomura: Article 50 and what could move GBP

Politics versus the BOE and UK data

In the month that follows the Article 50 trigger, the EU will publish the “Brexit directives” that will set the tone of the EU negotiation. From this it could be that the market attempts to price for whether it is likely to be a “good” or “bad deal” and if so will Theresa May follow through on her word on taking “no deal.” We think the market will care whether the exit and new arrangement discussions can take place in parallel (GBP positive) or if the EU sticks to a sequential process with exit talks first and nothing else discussed until they are finished. Given that would lengthen the talks it is likely to increase that “cliff edge” pricing (GBP negative) even though we assume that will not be the case.

While the market is pricing in the probability of a BOE hike we don’t think that will be until after Brexit actually happens. So while GBP is in a short-term uptrend for now, we are still struggling to see a material improvement in the medium-term outlook to justify going long GBP here. So we will continue to position to fade rate hike pricing by being long the belly of the curve via 2s5s10s.

What to expect after the UK triggers Article 50

Once the Article 50 starting gun fires, it will mark the end of the debate within UK politics and start the ball rolling with the real negotiation between the UK and EU-27. It’s hard to gauge every moving part and we expect many headline surprises along the way (as it is two years of negotiations after all), but here is what we can expect in the initial rounds of negotiation:

Fig 1 Brexit and the pitfalls of the Article 50 timeline.png

1. 29 March – The Article 50 trigger and a possible election: It should be a rather simple letter of notification that should not be market moving in itself. There has been speculation that this may be timed with an announcement of a snap election. This has been denied by the government so perhaps is not on the table. If an election were to be called, the market may take this positively, believing it could lead to a political turnaround, but instead it may put to bed the “Soft Brexit hopes.” If GBP were to head higher on the announcement of an election, we’d be looking to fade the move as the election would increase the uncertainty and not change the outcome of a “clean break” Brexit.

2. 29 April – The EU’s “Brexit directives”: Once the UK’s Article 50 is received by the EU-27 we should then expect the EU’s guidelines that will lay out the bloc’s priorities for discussions. It will be a public document probably published around 29 April. Its content will likely depend on the UK’s stated aims of negotiation but the main details that will prove crucial in negotiations are unlikely to be revealed so publically. These Brexit directives will also have to be signed off by EU affairs ministers in a qualified-majority vote, either in mid-May or mid-June.

3. Mid May – The first hurdle will be the initial formal talks only having a narrow focus: Once the French election is out of the way (7 May) and the EU’s negotiation guidelines are published, formal talks would likely be in Mid-May. It’s reported that Michel Barnier, the EU’s lead negotiator, is looking to ask member states to issue a directive to only cover the exit bill and citizen rights to narrow the focus of the initial talks.

What could impact the market:

 Sequential versus parallel talks? In our opinion, what could be crucial for the markets pricing of a “Good/Bad/Cliff edge” deal is if the EU sticks to its intention of sequential talks. In the scenario where the EU negotiation guidelines state that no negotiation on the future relationship will be discussed until the points of exit are agreed, namely the reported exit bill of EUR60bn and guaranteeing the rights of EU migrants among others it could prove to move GBP. On the flipside, if the EU were to allow for parallel talks the market may price out the possibility of the feared “cliff edge” moment and GBP would be the likely beneficiary as more could be achieved in the Article 50 window.

 Will the EU negotiators continue to have a unified position? So far the EU- 27 unity on the Brexit position has held firm, but it may be the first point where member states start to show signs of disagreement between those who care for the exit bill versus those who do not wish it to sour future EU-UK relations. The UK negotiators may be hoping for this as it would perhaps allow the UK room to manoeuvre.

 Will frictionless trade prove to be a pipe dream? Theresa May has said she wants a customs agreement with the EU that allows for tariff free trade and for it to be as “frictionless as possible.” However, on twitter Michel Barnier has already highlighted the preparation by the EU-27 on imposing future customs controls. If the free trade rhetoric turns protectionist, this could be the “no deal is better than a bad deal” moment where the market would further price GBP toward its “Hard Brexit equilibrium” of 1.15 to 1.18. The good news is that several trade experts agree that tariff free trade is more likely than not. But it is agreeing to common technical standards that are the hard part which will drag out the negotiations.

 Scotland to hold another independence referendum? As we wrote in European Economic Perspectives it is rather early to be focusing on opinion polls, which presently give a lead to the unionist camp so it is unlikely to see the market following each and every headline on Scotland. However, if a referendum is granted (and there is no guarantee at this stage that it will be) there will again be much debate about Scotland’s monetary arrangements, particularly in relation to EU/euro area membership. A referendum would inject further political volatility into an already uncertain state of affairs, potentially hitting sterling, consumer spending and business investment.

The “tick list” framework for GBP drivers

The Brexit story has many moving parts. From the potential for a detrimental impact on trade and financial services to the short term inflation story that has the BOE stuck between a rock and a hard place whether to react or not (we think not). So for transparency we’ve put together a brief “tick list” of factors that are driving the medium term bearish view on GBP.

Attempting to find a material reason to be long GBP, if you can’t, stay short The negatives of Brexit are well known and have already been widely covered. So to explain why we aren’t turning materially positive on GBP yet, we take the opposite approach. Find all the positives you can for why you should be long GBP and one by one cross them out if they aren’t good enough to offset the negatives. The day you find it to be a more balanced pros/cons list will be the day you switch long GBP, but we are not there yet, in our view (see Figure 2). But for argument’s sake let’s go through the positives.

Fig 2 The Factors Driving our GBP outlook

What could drive GBP higher?

April typically sees a positive GBP/USD seasonality effect

It’s always hard to fully explain the reasoning for seasonality where most often it is due to a series of coincidental macro-economic catalysts (see The “sell in May” phenomenon). In a perfect market the pattern should not exist but FX is not perfect and there is a pattern of GBP/USD upside in April. It was 2004 when GBP/USD fell by 3.7% which was the last time buying GBP/USD in April failed to work. Since then, GBP/USD on average has appreciated by 2% with 12 years of this being a successful strategy. However GBP/USD has proven volatile as of late and March has seen a 3.5% low to high, so playing for this 2% seasonality alone is perhaps not so clear, but it is a risk to watch for if short (Figure 3).

PPP says it’s a buy, but a mean reverting argument for GBP seems too simplistic

“GBP is low” versus normal PPP valuation measures and is somewhere between 0-25% undervalued depending on your assumptions (Figure 4). Typically on its own this would make GBP look attractive for a long term investor but that is not enough. Ask an investor who has been buying EM currencies that have deviated from their long run value (think TRY, 176% undervalued and climbing…) or for a more fair comparison with GBP take a page from the pain trade of selling CHF because ”it’s overvalued.” Currencies either deviate from long run PPP for a considerable amount of time due to one off factors or there is a risk premium attached that following inflation based valuation metrics will not quantify. For a normalization toward the fair value, we may need to see changes in flows or/and policy stances. For example an undervalued currency tends to lead to 1) a better external balance and 2) a hawkish central bank owing to higher inflation from imported goods. These can both change the supply/demand dynamic of a currency, correcting the valuation mismatch. However, we have not yet seen any clear improvement in the external balance yet. The recent hawkish stances of some of the BoE members may be an initial sign of the correction, but it is too early to expect the BoE to consider hiking soon. Therefore the undervaluation of GBP should sustain.


Fig 3 GBPUSD April seasonality
Fig 4GBP is up to 25% undervalued on PPP measures

Is “Hard Brexit” really fully priced in? It’s not clear to us that it is

In the case of applying a risk premium argument to GBP, it does at times feel like a good deal of “Hard Brexit” is already priced in, especially after observing the rally following Theresa May’s Lancaster house speech. So the argument would follow that from here the only way is up as the risk premium should slowly abate. But we would advise caution, as the market is unlikely fully pricing the possibility of a “clean break” Brexit. There remains the big question mark as to what Brexit means for financial services (see Banks’ exit from the UK – potential impact on the economy and flow) and what another Scottish independence referendum would mean for the UK (see UK: A second chance for independence). Both of which we won’t go into detail here but refer you to the above pieces where we explain it leads to higher levels of uncertainty and lower growth/GBP.

The flows are why we continue to expect GBP to underperform

Real Rates continue to deteriorate in the UK and the flow picture is uncertain

Gilts continue to outperform but, as inflation heads higher, the UK has dropped into second to last place on the ranking of its real rates among the G10 (Figure 3). As we wrote in Real rates point to GBP weakness but …the politics and BOE noises may cause short squeezes higher but the inflow picture for the UK looks fragile given a deterioration in the real rates picture and equity valuations. It’s only if the BOE were to materially turn hawkish that the real rate picture would improve. The M&A flow has also turned negative with a few outflow transactions from the UK (see M&A tracker: Is the US becoming more attractive?), while high frequency data suggest in general the inflows have been more erratic (Figure 4) but showing a slowdown too. With the GBP devaluation and higher rates abroad the income balance may improve and with it the current account. However, it will likely take some time before the goods balance adjusts, considering GBP has fallen 28% since the financial crisis and it is yet to improve (see Sterling’s “Hard Brexit” equilibrium).

Pricing in a rate hiking cycle from the BOE is a stretch

GBP has begun to react to the data (see Real rates point to GBP weakness but …) but it’s not good news on that front. GBP has traded higher recently, due to the higher inflation and retail sales surprises spurred on by a more netural BOE stance in the minutes. It has also led to a steeper SONIA curve (see UK: MPC’s hawkish tilt… for now) that is now pricing in a hike around Q3 2018. But what we may find in months to come is a slowdown in the UK growth and consumer spending data that will see the optimism fall once again. We expect the BOE to look through the short-term inflation overshooting moves and revert back to a more neutral to dovish stance as the data trend will continue to falter. In our view, it will be another example of the market getting ahead of itself by pricing in rate hikes in the UK. It’s why our rates strategy team is opposing the pricing in of hikes by going Long the UK belly of 2s5s10s.



Fig 5 UK real rates continue to deteriorate
Fig 4GBP is up to 25% undervalued on PPP measures

If we are proven wrong though, what you need to know about the BOE’s first hike is that typically GBP rallies into and through the rate hiking cycle unlike the USD which tends to underperform during a Fed hiking cycle. But the lesson from the timing of the first piece above (published in July 2015) is that it may be proven to be too early to be applying that framework once again as we have found when writing similar pieces about their first hike since 2014.

Rates strategy

With our expectations for the MPC to be on hold until Brexit has actually happened, our front-end view is one of range trading where we think there will be good opportunities for investors to profit. We think in terms of how many hikes are priced between ‘now’ and Brexit. Using the short sterling strip as our guide, we currently have 38bp of hikes priced in. We think fair value for this is 10-15bp but that the market will range around. At these levels we would be bullish, which we currently express via long 2s5s10s (very directional but some extra value in this expression). We would be looking to take profit when the number of hikes price din pushes down to the 20bp mark.

Perhaps one of the most interesting aspects for the UK rates market in the Brexit negotiation period comes on the cross-market side. Metaphorically speaking, the UK rates market is often seen as in between its bigger peers in the US and euro area, and is heavily influenced by both. However, for the next two years the UK has its own independent, idiosyncratic event. So where we would normally expect it to move around with US and euro area rates, with a beta a little lower than the US and higher than the euro area, it should be charting its own path. Thus, if we see the UK trying to price in hikes just because these other rates markets are, there will be opportunities to be long the UK on a cross-market view.


Article 50 negotiations will likely prove to be a drag on GBP but it is not just Article 50 that will be moving GBP. We cannot deny the BOE surprised us all by taking a more hawkish tone in the March minutes. The positive surprise in UK CPI will further test the limits to the BOE’s patience of an inflation overshoot, but high inflation alone will not push them to hike. In our view, it will require much higher levels of wage growth and/or a material pickup in the consumption data to realistically prompt the BOE to hike. While GBP is in a short-term uptrend for now, we are still struggling to see a material improvement in the medium-term outlook to justify going long GBP here.

Marketing communication : This document has not been developed in accordance with legal requirements designed to promote the independence of investment research and its author(s) is/are not subject to any prohibition on dealing in the relevant financial instrument ahead of the dissemination of the marketing communication.

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