UK: Too early to price soft Brexit, GBP outlook very negative – Deutsche Bank

Following the outcome of last Thursday's UK election, developments over the weekend have provided sufficient evidence of uncertainty over shift towards an openly softer Brexit plan or a continuation of the status quo which are particularly negative for sterling.

Key Quotes

“Here are the three main considerations:

(1) It is premature for the market to start pricing the soft Brexit narrative. It is becoming increasingly apparent that no politcal party or grouping has an incentive to change the status quo. The Conservatives are worried about a leadership battle/early election as it would (a) increase the probability of a Labour victory and (b) lead to a likely split of the party itself as it is impossible to reconcile the views among the hard/soft Brexit supporters. Labour does not have an incentive to clarify its Brexit position (it remained very vague over the weekend), but instead allow the Conservatives to bear the cost of any decision. The Prime Minister does not have the political capital to change the existing Brexit negotiation guidelines as she would be at risk of alienating the left or right of the party. The conclusion is that we are highly likely to end up in a period of acute political paralysis in coming months.

(2) As a result of the above, the risk of a disruptive Brexit is rising. Because the timelines are fixed, the more decisions are delayed, the greater the risk that there is no time left to negotiate something non-disruptive. What is more, precisely because the incentives are aligned for paralysis, external market or political pressure will likely be required to align politics towards a decision. This could happen either happen (i) via Europeans elevating the pressure even more and threatening “no deal” in the hope of a second referendum or an even friendlier election outcome, or (ii) via economic and market pressure as uncertainty rises as the Brexit departure date approaches, forcing clarity to avoid a deep recession. The key point is that things will probably need to get worse before they get better - without a crisis, negotiations are simply likely to stall until the “hard” 2019 departure date.

(3) All of the above increase downside risks to an already gloomy outlook for the UK economy. Uncertainty is likely to affect household and corporate spending decisions more than after the Brexit vote because a) A50 has been triggered and corporate decisions will now have to be based around a worst-case scenario and b) the ability for households to offset falling real incomes via borrowing is now much more constrained with the UK savings rate at a record low and banks tightening lending standards after concerns expressed by the PRA. This should leave the Bank of England on hold as the Fed and ECB tighten and push interest rate differentials further against the pound.”