The Intractable Irish Question

There are three issues that the EU insists are addressed before formal discussions about the post-Brexit UK-EU relationship.  These are EU citizens' rights in the UK, the British financial commitment, and the North Ireland border with the Republic of Ireland. 

Progress has been reported on the EU citizens' rights, and speculation suggests that UK Prime Minister May is prepared to shortly (within the next two weeks) raise her to offer closer to the figure that some EU officials have mentioned (60 bln euros).  Many had expected the financial negotiations to be the most difficult, but it now seems that the Irish border issue may be the most intractable.  In fact, it may turn out to be the deal breaker in the sense that a solution may not be achievable in the next two weeks.  This, in turn, may prevent the EU Summit next month to allow the new phase in the negotiations to begin. 

Why is it intractable? Don't all three parties (Ireland, UK, and EU) agree that a hard border is not acceptable?  The problem is that Ireland and the EU want Northern Ireland to remain in the EU's common market and remain subject to the EU customs and internal market rules even after Brexit.   Ireland is also concerned that a hard border would undermine the Belfast Agreement (aka Good Friday Agreement), which was vital in the peace process.  Peace between the Catholic and Protestant parts of Ireland was forged within the EU framework.

 There was one major political group in Northern Ireland that opposed the agreement.  The Democratic Unionists.  UK Prime Minister May changed the fiscal priorities of the Tory government that she inherited from Cameron.  She also maneuvered to hold snap elections, which went against the spirit of the election schedule that Cameron's government implemented. The main thing she kept was Cameron's willingness to make binding the non-binding referendum.  In any event, upon losing the Tory parliamentary majority, May sought out a coalition with Northern Ireland's Democratic Unionists.

To be sure, the UK is not just balking at the Irish demands because of the Democratic Unionists.  Conceding the regulatory authority to the EU over Northern Ireland would be tantamount to an abdication of UK sovereignty.   The UK's Davis (Secretary of State for Exiting the European Union) rejected the idea that Northern Ireland will remain in the single market.  A hard border within the UK is unacceptable to the British government and a hard border between Northern Ireland, and Ireland is not acceptable to Ireland and the EU. 

Nevertheless, given the economic ties (e.g., bilateral annual trade ~65 bln euros) a disorderly UK exit from the EU would hit Ireland harder than most of the EU.  Ireland's Prime Minister Varadkar argues that it is incumbent on the UK to propose a solution.  He called for "specific assurances and written guarantees."  The Financial Times reports that despite Varadkar's claim that top European officials support his position, "it is quietly acknowledged in Dublin that other member states are unlikely to tolerate a breakdown over Ireland is money and citizens rights are settled."

Even if the Financial Times assessment is correct, it still does not make an acceptable solution any clearer. There are alternatives, but they may require imagination and strong leadership, both of which are not in large supply at the moment.  For example,  the Isle of Man may offer a model, though may not be a perfect example of what is possible.

The Isle of Man is a self-governing Crown Dependency between the island of Ireland and the island of Britain.  The Queen of England is the head of state, and the UK is responsible for defense and foreign policy.  The local parliament is responsible for all domestic policies.

The Isle of Man it's not part of the British Commonwealth, but participates in some of its institutions.  It is not a member (or associate member) of the EU.  However, under the Treaty of Rome, it is part of the EU customers area.  There are, though, some limitations on the movement of capital and services.   The Isle of Man is also a tax haven insofar as there are not capital gains, wealth or inheritance taxes, or corporate taxes, and the top income tax rate is 20%. 

In any event, the EU chief negotiator has given the UK two weeks to clarify its position on the three outstanding issues.  UK Prime Minister is in a weakened position has illustrated by the reports suggesting that 40 Tory MPs are ready to sign a letter of no-confidence.  Another eight would be needed to trigger a leadership challenge.  It is not clear who could succeed May if it comes down to that.  The bookmakers are divided.  Three bookies have three different candidates favored Jacob Rees-Moog, David Davis, and Boris Johnson.

What worries many investors is not simply that there is not a single candidate that has emerged, but that some of the suggested candidates may actually be worse for investors than May. And this is not to even discuss the economic straits of a slowing economy and compression in household purchasing power, which will likely be brought to the fore this week with inflation, employment/earnings, and retail sales reports slated for release in the coming days.

Sterling remains within a five-week trading range of roughly $1.30 and $1.3320.  Speculative positioning in the futures market is roughly balanced between the bulls and bears, leaving a net position of long 1.2k contracts.  The US two-year premium over the UK has to rinse from the year's low of 90 bp in mid-September to nearly 120 bp here in November.  The high for the year was set in March a little above 130 bp.  The three-month (25 delta) risk-reversals (skew between calls and puts) show a premium for sterling puts, but that premium had been falling since early October, until today.