Ahead of Brexit Cable Dives but Then Recovers

Market Drivers March 29, 2017
Cable plunges in Asia but rebounds
UK Mortgage Approvals dip
Nikkei 0.08% Dax 0.48%
Oil $48/bbl
Gold $1252/oz.

Europe and Asia:
GBP UK Mortage Approvals 68.3K vs. 69.6K
GBP Consumer Credit 1.44B vs. 1.3B

North America:
GBP PM May announceds Brexit 7:30
USD Pending Homes 10:00

Cable tumbled hard in Asian session trade today dropping more than 70 points in a matter of minutes after Theresa May signed the letter formalizing UK intention to invoke Article 50 and exit the European Union.

The actual notification will take place today at approximately 1130 GMT but traders reacted ahead of the event, although the action was never really in doubt. After breaching the 1.2400 figure cable spent the rest of the session consolidating and then rebounding back to the 1.2450 level.

The short squeeze in early London lost most of its momentum after leaks the EU President Donald Tusk's speech suggested that the common market would take a relatively tough line in negotiations. Mr. Tusk is expected to state that no free trade deal will be given the UK in the first two years of negotiations and that even as of now, while UK remains within the union, the terms of trade will no longer be as favorable. Overall, the EU has allocated 3 years to get the deal done as both parties negotiate the Brexit terms of separation.

Much of the GBPUSD trade will depend on the state of negotiations with the EU once Article 50 is triggered. There are two camps of thought with respect to the UK exit resolution. Cable bears are convinced that the EU will want to "punish" the Brits and make an example out of them so that no other member of the union decided to secede. The "hard Brexit" scenario calls for very harsh trade terms for UK, as well as heavy penalty fine for the right to exit.

Most analysts, however, believe that it would serve neither party well to have a difficult divorce. UK, after all, is not only the second largest economy within the bloc, representing massive consumer power to the rest of the continent, but is also the global hub of international finance serving as a very valuable intermediary between Asia and, Middle East, and North America. It is perhaps this aspect of Brexit that is most overlooked in market analysis. While most traders are focused on the state of trade flows – the key to UK's economic survival will be the state of capital flows. For all intents and purposes, UK is a finance economy and finance is its greatest product. That's why the survival of UK finance sector will be the key to the survival of UK economy as a whole.

The central conflict between the UK and the EU is that Great Britain wants to have full access to the European market while restricting the movement of EU citizens within its own borders. That simply will not fly with the Europeans whose system is based on the fundamental premise of the free flow of goods, services, and individuals. If UK stubbornly clings to its nativist stance without some compromise, the selling pressure on cable will likely accelerate.

For now, the market remains relatively sanguine about the prospect of Brexit. Currency markets are assuming that some sort of workable compromise will be made as Brits agree to a breakup fee and some limited freedom of movement for EU citizens in return for only modest barriers to the EU market. Under such scenario, cable could find a much more sustainable bid and could slowly trade towards the 1.3500 level. If, however, the parties dig in on the freedom of movement issue the long protracted negotiation with all of the concomitant recriminations is likely to cast a pall over the UK economy. Business investment will freeze and further pressure on the pound will create stronger inflation and dampen consumer demand.

For today, the price action will likely remain contained in the 1.2350 -1.2550 corridor depending on market's reading of initial negotiating stances. This, however, is just the beginning of the process that will no doubt see many ups and downs along the way.