Brexit Talks are Sterling’s Nightmare

Sterling’s performance in post-Brexit environment is a triple issue factor with Brexit talks, monetary policy outlook and macro picture of the UK economy being the main drivers.

With Brexit talks in a deadlock and the European summit due next week seen unlikely to break the stalemate, the prospects for sterling are rather negative, regardless of macroeconomic framework increasingly pointing to monetary tightening by the Bank of England in foreseeable future.

Brexit talks

The Brexit talks are deadlocked for now and with the European summit due next Thursday and Friday and little-to-no progress in Brexit talks the pressure on British Prime Minister Theresa May mounts. This is what we heard from chief Brexit negotiator from both sides of La Manche channel this week. “As things stand at present, I am not able to recommend to the European Council next week to open discussions on the future relationship,” Michel Barnier, EU’s chief Brexit negotiator wrote in a statement on Thursday.

The key issue is money. Of course. The UK is reportedly trying to focus on opening the trade talks as early as possible in order to keep business flowing. The EU on the other hand presses on financial commitment Theresa May promised in her speech in Florence together with some kind of transition period during which the UK will maintain payments to the common EU budget. No one on the side of EU 27 is though willing to give up hard stance and the foreign market reaction to the deadlock was massive decline of sterling against the US Dollar by 140 pips. At the same time, the market saw massive rebound backed by rumours of transition period being an option, at least from Barnier’s personal point of view. For going further, Barnier needs a broader mandate approved by the EU 27 leaders, which is unlikely.

Countries like France and Germany, key players in EU, are opposing the idea of transition period. Moreover, German chancellor Angela Merkel is still busy trying to form the government at home.

The Brexit negotiations issue is big. The cost of Hard Brexit could be enormous with analysts from Rabobank expecting it to be  as high as GBP 450 billion.

The economy and the interest rate outlook

Mark Carney, the Bank of England governor, is stuck in a hard place. The UK economy is slowing down apparently and the inflation is well above the inflation target. The headline CPI inflation is expected to rise 3.0% over the year, the figures from the Office for National Statistics are to show next Tuesday.

Although the unemployment rate in the UK is at 4.3%, the lowest level in last 42 years, this is not lifting wages that are key drivers of household consumption and overall GDP growth. The wages are expected to rise 2.1% over the year in August, the labor market report is due to show on Wednesday next week.

With prices rising by 3% and wages rising by mere 2%, the real income growth is negative, posing a main threat to potential growth in the UK and at the same time makes it harder for the Bank of England policymakers to step up with monetary tightening, regardless of clear inflation related policy mandate.

The financial market is currently pricing around a 75% probability of a rate hike by the Bank of England on November 2nd and therefore the CPI and labor market report due next week are very important for the market players.

With inflation and wages both rising above expectations, the chances of November rate hike increase supporting the sterling’s value on the forex market.