The implications of Brexit’s ‘last mile’

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Ian Pollick: Hi, everybody, and welcome to another edition of Curve Your Enthusiasm. My name’s Ian Pollick, global head of fixed income, currency and commodities strategy here at CIBC Capital Markets. We’re going to take a little departure this week and travel across the pond with our colleague Jeremy Stretch out of G10 FX strategy. Jeremy’s going to join us today to give us an insight on what’s going on with Brexit, key developments in terms of the timeline and what we can expect in terms of market behavior. Ultimately, we’re going to bring that back and see what it means for the Canadian currency as well as the rates market. Jeremy, thank you very much for joining us today. How are you?

Jeremy Stretch: It’s a pleasure to join you today Ian. And all is well from here in London.

Ian Pollick: Glad to hear it. So let’s not waste time and let’s kick it off. Why don’t you give us a little bit of background in terms of what we can expect over the next couple of months with Brexit, some of the recent developments and generally on a high level view of what your thoughts are?

Jeremy Stretch: Well, here we are now coming to the end of the Brexit implementation period. So the UK, of course, voted to leave the European Union back in June 2016. And it does seem like almost ancient history even before the US had voted for President Trump, which just puts it into some degree of context. And here we are still discussing the whole Brexit exit process. But the UK has formally left the European Union. But we, or the the UK as it is, is currently in what is called the implementation period, where all the rules and regulations remain the same until the end of this year. So 31st of December. But this implementation period has been designed to allow the two sides to negotiate the future trade arrangements. And that’s really been a fairly tricky and thorny set of negotiations which have been ongoing over the course of the last few months. And that ninth and final formal round of negotiations are currently underway as we speak. They began back on Tuesday in Brussels and they will run through to the end of Thursday. And then we will have a briefing of the chief negotiators on Friday the second, to give an update as to where the two respective camps actually sit. Now, there are two particular sources of contention which are really holding up negotiations as we speak. One is in relation to fishing and now this accounts for 0.044% of UK GDP. But it’s something which is very emotive and is seen as one of the key emblematic issues for the Brexit process. So that is one factor which has been holding up the negotiations. The other is in relation to state aid. And it does seem to be the case that the mood music, which had looked much more optimistic about a deal as recently as the back end of last week, in the beginning of this ahead of this week’s negotiations, that optimism has been reduced or compromised a little bit because the latest plans that have been instituted by the UK have been pushed back by the European Union. So as yet, we are still awaiting some degree of resolution in this negotiation process. And that’s important because the implementation period runs at the end of the year. But there is going to be a key EU leaders summit on the 15th of October. And the UK has decided that if there isn’t sufficient progress by that time, it may well walk away from the negotiations. So we are getting very close to the end game. As far as the whole Brexit process is concerned, the stakes are getting higher. The game of poker is becoming a little more extreme. And so that does really add to the headline risk for markets as we move across the next two to three weeks in particular.

Ian Pollick: So listen, I think that when we think about Brexit risks, one of the things that I cannot divorce from the discussion is some of the nuances happening in the UK right now. Maybe you could just speak to us a little bit about re-emergence of Covid cases, how that factors into the macro data relative to the Bank of England’s assumptions, because correct me if I’m wrong, they are expecting a V-shape recovery. How are you thinking about that right now?

Jeremy Stretch: Well, it’s a very good question. I think in the first instance, from the shape of the recovery, the Bank of England are aiming to be quite optimistic in terms of their macro outcome. So they are assuming that there will be a V shaped recovery to such an extent that they’re assuming that by the end of next year, the economy will have made up the lost output, which we’ve seen in the first half of this year. And we have just seen the final estimates for Q2 GDP revised up. So that’s good news. The upward revision has taken that contraction in the second quarter from minus twenty point four percent in the quarter to minus nineteen point eight. So it’s an improvement, but it is still a pretty disastrous backdrop. And of course, that’s a quarter on quarter number, not the seasonally adjusted annualized numbers that you get in North America. Just to put that in some degree of context. To the banker, assuming that there will be a substantial V shaped recovery, I think that there is some legitimate questions to be raised by that, because I think the unemployment backdrop is going to be much more challenging. And, of course, the UK economy is uniquely exposed to service sector activity. And we have seen a substantial uptick in Covid cases here in the UK over the course of the recent weeks and indeed into the end of September we’ve seen fresh record daily highs in terms of Covid cases. And so that is leading to increasing levels of local lockdowns. And that will have immense headline risk of macro risk in terms of the service sector activity levels. But I think there is going to be some question marks about the growth trajectory in Q4, which I think makes the V shaped recovery that the Bank of England is discounting a little more optimistic. I think that will probably imply that the Bank of England will be forced to adjust their bond purchase program come November to add more liquidity into the system. And the question is, how do those sort of covid related issues pare back into the Brexit debate? Well, I think the UK government have latterly, or certainly over recent months looked at those two issues in isolation. So they’ve been thinking about the ramifications or the immediate ramifications of the first wave of Covid and then moving forward to think about the prospective second wave over the winter in isolation from the potential headline risks of a no deal Brexit. But now is that a Brexit timeline tightens and we continue to see that rising numbers of cases I’ve covered in the UK, there is now an increasing realisation that those two factors are and should be looked at as a complementary headwind to the UK macro outlook. And I think that’s one of the reasons why I think the UK government is perhaps softening in its time just a little bit vis a vis the negotiations, because there was a realisation that the UK economy, having suffered the greatest contraction of all the major economies in the second quarter, is probably least able to be able to face the twin trap problems of service sector uncertainty due to the second wave alongside that potential for a no deal Brexit.

Ian Pollick: I think you brought up a couple of very important points, I just want to dig down a little bit more. I think the realization that relative to the composition of the economies in other parts of the developed markets, UK is disproportionately reliant on services, even that Covid is going to potentially push more lockdown’s restrict that service activity from growing. It does put more considerable downside risk because less benefits from a manufacturing sector that deep and when we think about the gilt market, for example, we know that the front end is hesitantly looking at negative interest rates. I’d like to ask you your opinion on that in a second. But when we think about the global macro narrative right now, correct me if I’m wrong, but it does feel like many parts of the world are moving together in lockstep, particularly in North America, which makes, for example, Canadian interest rates, by and large a derivative of US treasuries. But that’s not the case for gilts, given what we’re talking about, a potential deeper impact from Covid, the discussion around Brexit, which could lead to some near-term optimism, which we haven’t had in a while, but also the Bank of England sounds very adamant on adding additional QE. I believe he said another hundred billion and that should actually lead to a much flatter curve led by the long and coming in relative to the short end. What do you think that might mean for Sterling, just given that there is newfound attractiveness of gilts, but also what does that mean relative to the negative rate story?

Jeremy Stretch: Well, so many good questions in the context of that Ian. I think what I would say is you’re absolutely right that in the prospect or with the prospects of the Bank of England looking to adjust their purchase program by adding more purchasing power to the asset purchase program in November, then that should provide a further sort of position of a flattening of the curve in terms of the UK. I don’t think the negative rate story, I think will garner any real significant traction unless there is a no deal Brexit. I think that’s the nuclear option that the Bank of England are holding back as a potential offset to any uncertainty in terms of that no deal outcome. And that is not our central case scenario. We still think that there will be a deal eventually agreed, but a relatively thin one at that. But I think in terms of Sterling and Sterling’s performance, I think there are some key variables to consider. Now, of course, the biggest variable is the expectation of both the macro story and how the narrative plays out relative to elsewhere. But of course, that no deal Brexit dynamic is also an integral part to the performance of Sterling. So I think we can safely say that the outcome of the Brexit negotiations will see a non symmetrical reaction in Sterling. Now, what do I mean by that? Well, we saw immediately after the vote back in 2016, Sterling dropping by the region of all the magnitude of around 15 per cent against the US dollar in the immediate aftermath of that decision. I think from the context of Sterling, you would potentially argue that there will be a similar potential downside risk in the valuation of Sterling from the recent highs, up near 135 against the US dollar if there were to be a no deal outcome. So that probably would suggest that there would be a magnitude of a correction back towards the sort of 115 116 level against the US dollar. However, the flip side of that is that if we were to get a deal or if the UK is to get a deal and I think the potential upside risk is much more contained, yes, there will be scope for recovery. But I think it’s very difficult to see necessarily Sterling rallying up above those recent highs that we saw in late 2019 and again this year up around the sort of the 135 threshold. So I think there’s a non symmetrical outcome for the UK’s dynamics in terms of the performance of Sterling. I think that it is geared largely around the outcome of the Brexit debate. But as you say, I think there is going to be an impact in terms of investors looking for an opportunity to diversify some of their portfolio. And in an environment where UK inflation is going to be relatively contained and we are going to see a relatively flat curve, then I think that does provide some interest from Sterling. But it does really relate back to the dynamics of Brexit being the ultimate arbiter in terms of where we will peg our sterling forecast going forward. Our House view is that we will get a deal, and I think that will imply that we can and should see some modest sterling impetus in the latter stages of this year.

Ian Pollick: Well, that’s interesting, because one of the things that I’ve been noticing, Jeremy, is that when I were to look at a simple correlation between Sterling and the S&P 500, you’re now seeing levels on a 90 day correlation where Sterling is the most positively correlated to US stocks that it’s been in almost two and a half years. Why is that? Why are we seeing in a pandemic environment an economy that is very pressured by a service sector with the potential for negative rates to be implemented? Why are you seeing such a tight correlation between sterling and risk assets? And yet when I looked at currency returns, the British pound is the ninth worst returning currency out of the G10.

Jeremy Stretch: It is quite interesting that in a sense, as the UK has been engineering its exit from the European Union, I think the market has taken on board increasing realisation that the UK in a more isolated economic environment going forward, if it’s going to be outside of the remit of the European Union, does mean that there is a greater degree of susceptibility to asset flows and or market risk appetite because, of course, the U.K. continues to run not only a very large and expanding fiscal deficit as a consequence of the Covid crisis. And of course, the U.K. is not unique in that. But also the U.K. runs a fairly sizable current account shortfall. So the U.K. is always reliant on hot money inflows. And so it does sort of tend to follow that in an environment where the currency is reliant on those fund flows to support the current account shortfalls. When we do have episodes of risk on or risk off trading. It does seem to have a disproportionate impact in terms of the appetite of financial markets for Sterling as a riskier based asset. So I think the UK’s risk variability, I think, has been enhanced by the whole process of the exit from the European Union because it just underlines that the UK is having a greater degree of sort of dislocation from its primary trading partner, which, of course, the European Union is in terms of goods as well as services. So it just means that that funding of that current account shortfall and the reliance on hot money inflows becomes ever more important. And of course, that’s linked to asset markets and market risk appetite or risk aversion, depending on which side of the coin you looking at at any given time.

Ian Pollick: That’s a good answer I appreciate, and that does make a lot of sense. Now, one of the things that I’ve been thinking about and remember, I tend to think of the world and markets from a fixed income point of view. But something that strikes me is that I wonder if when we look at the behaviour of Sterling relative to assets or other currencies within the European time zone, such as CHF or Euros, do you see any type of behavioural change in sterling, assuming that we get Brexit done? It is not as contentious as people fear. You end up with a macro profile that’s pretty consistent with your own. Do you see a behavioural change in the way Sterling trades relative to, say, the euro relative to the Swiss franc or relative to the yen? Are we going to see that behaviour that we just talked about where there’s more risk appetite coming into the market that’s having more of a defined impact on Sterling? Do you expect some of those crosses to breach key levels and is exposed to world of Brexit?

Jeremy Stretch: That’s a tremendously interesting question. I mean, I think it’s absolutely right that because the UK is embarking on a new world environments in terms of its economic dynamics, then it is going to make sterling trade in a slightly different orbit in the way that we would have otherwise have seen it trade, I think, in the context of the UK versus the euro. Well, obviously, those traditional macroeconomic metrics visa vi the monetary policy story and the growth trajectories will still be ultimate drivers of currency performance. And one of the big structural changes going forward will be how will the UK prove or provides an opportunity for foreign direct investment to come into the UK? Because I think that’s going to be one of the big structural changes that I think is going to impact the performance of Sterling, because, of course, in the last 20 to 25 years in particular of the second half of the UK’s membership of the European Union, the UK has been the largest inward destination for foreign direct investment within the European Union because of its lightly regulated labour market and highly educated workforce and relatively flexible and nonunionized backdrop. So that’s provided significant inward investment opportunities into the UK because of the legacy of being able to then export into the single market of the European Union outside of the European Union it’s going to be interesting to see whether the UK can and will be able to attract the same level of foreign direct investment inflows. And I think that’s going to be one of the more important dynamics. I think the one obvious important distinction between those other three currencies that you’ve mentioned is, of course, those three currencies are all current account surplus nations. And so invariably they’re not as susceptible to the risk on risk off dynamics that we were recently talking about in terms of the currency performance. So I think inevitably, I think the UK is going to find itself even more correlated with those sort of risk metrics going forward. But I think the other variable that is going to be most important on a medium to longer term structural dynamic for UK PLC is how or if the UK is able to attract foreign direct investment relative in particular to the eurozone in order to offset that current account shortfall. And that would provide some stabilisation and support for sterling valuations going forward.

Ian Pollick: Well, thank you for that. And I tend to agree with you. And I want to switch gears and move back into the rates market for a second, because when I look at the short sterling strip, it strikes me as a bit odd that the first instance of negative rates isn’t being priced until mid 2021. But then if I look further at the curve, it looks like there’s an escape from that negative rate pricing scenario as you get into 2023. If the Bank of England had to go into negative rates, do you think that it would be as short lived as being implied by the market or would it be something where it’s somewhat of a liquidity trap that we’ve seen in other jurisdictions, that of adopted negative interest rate policies.

Jeremy Stretch: Well, I was just listening to your question and I was just about to reply with the second part of your question, and I think that’s actually the issue or one of the issues that I think the Bank of England are very mindful of is the fact that there is that difficulty of extracting oneself from that negative rate environment once you’re in. It’s the example of the Riksbank is one which I think is quite pertinent in that regard because it did take them. That’s part of half a decade to extract themselves from negative rates, even though they decided that the efficacy of the strategy was questionable. And I think in the context of the UK in particular, in terms of the reliance on consumption and consumer spending, you could argue there is some validity in trying to enhance that by moving into negative rates. But I think in view of the degree of indebtedness in the UK and in terms of the imbalances, in terms of spending and saving that I think it will be very, very difficult for the Bank of England to extract itself quickly from a negative rate environment, unless it was a very, very short, sharp shock in the course of almost a quarter, which would almost make it a non worthwhile risk to take. So I think the banks are very mindful that the unintended consequences or the risks of embarking on a negative rate strategy are sufficiently large that it would potentially make that endemic liquidity trap one which will be very, very difficult for the UK central bank to climb back out of. So I think that’s why I continue to argue that the negative rate story is akin to that nuclear button. It’s something you have there as an opportunity to say, well, we could do this if we have to. But I think there is very much an emphasis on if we have to, but rather we would really prefer not to have to do that. And I think that’s the way that the bank will continue to follow their policy remits going forward.

Ian Pollick: I tend to agree with you. And just to summarise, for all of our listeners today, when we talked about the idea of some of the bigger risk they’re facing the UK economy right now, obviously, Jeremy, it sounds like you’re a bit less optimistic relative to the Bank of England’s base case scenario, reflecting the fact that overall macro activity is going to be pressured downwards just given the sensitivity of the service sector to some of the covid related dynamics, such as Lockdown’s. But that should create some diversification benefit. When you think about a global portfolio, there is reason to believe that you will gain some capital appreciation on gilts. And that really follows from the fact that as a result of that macro narrative, you do expect the Bank of England to inject another 100 billion of liquidity through quantitative easing that should, in turn help to flatten the UK curve. And quite perversely, as you start to see hot money come back into the country to take advantage of that rate dynamic, it could in turn bid up Sterling further flatten  that future inflation profile and all that really suggest to you that when we take this to the limit, it’s very unlikely that this strip being priced in right now from the short sterling strip, I should say, is a bit unrealistic. Would you agree with that broadly?

Jeremy Stretch: Absolutely. I think you can captured what I’ve been trying to say very, very well. You’re absolutely right. I’m somewhat less optimistic than the Bank of England. Of course, I’d love to be proved wrong. In the UK, economy bounces back far faster, but I think it’s more likely that it’s going to be early 2023 rather than the end of twenty twenty one that the UK economy manages to take back the degree of loss of output and productivity that we’ve seen in the post-Covid world. As we’ve said, I think there is a greater dependency on that service sector. And of course, you know, when we’re talking in the UK hospitality industry with potentially a million jobs at risk of being lost over the course of the next three to six months, if the UK does see increasing degrees of lockdown through the Northern Hemisphere winter, then it’s very difficult to foresee those sort of headwinds from the macroeconomic environment not playing out and having an impact in terms of policy. But as I say, I think the Bank of England would prefer to continue to utilise their asset purchase program rather than embarking on anything more akin to that nuclear option. If we can see the UK getting a deal, however thin it may be in terms of the negotiations with the European Union, which is, as I say, I think is still the baseline scenario because it’s in the best interest of both the UK and Europe come to some degree of resolution. Politically of course, there is a very different perspective from the UK because the UK government were elected on the narrative of getting Brexit done and striking a strong deal. But I think they can and will be able to sell domestically an issue which is not necessarily the optimal economic outcome, but will be the least worst perspective. And if you start to get to that sort of presumption in terms of avoiding that no deal Brexit, then I think that has some scope for some degree of sterling valuation going through the course of next year. And that ultimately will help to mitigate any upticks in terms of the inflation profile.

Ian Pollick: Well, thank you for that. And I think for those of us on the phone who are thinking about some interesting cross market trades as it pertains to Canada, what I’ve heard from this conversation today is that there is a decent amount of flattening momentum that could potentially come into the gilt curve. When we think about the North American curves, our regular listeners and our regular readers know that our bias is to see a steeper term structure, but potentially, we should be talking about flattening the U.K. curve, steepening the Canada curve, that would make a lot of sense. Maybe we’ll put something out on that in the coming weeks. Before I let you go, Jeremy, and thank you very much for joining us today. What are your favorite trades right now as regards Sterling or other currencies that we should be talking about?

Jeremy Stretch: I think the problem in the very short term in terms of Sterling is that a susceptibility to headline risk. So I think that does cause some degree of consternation in terms of sort of trading sterling from a very short time perspective. But I think ultimately, if we’re right about the deal being struck in terms of the negotiations with the European Union, then I think that does provide scope with Sterling at current levels against the US dollar to provide some value in terms of trading that through the US election. Now, I know that there’s going to be election risk and election uncertainty, but I think that can and will play out. And we can see Sterling rallying by three to three and a half figures against the U.S. dollar towards the end of the year. So I think that will be a relatively constructive backdrop going forward. So I think that’s one that I would certainly be liking to play. And I think also in that perspective, if we all going to see the U.K. and the European Union provide some degree of clarity in terms of the Brexit outcomes, then I think that will also take away a little bit of negativity on the euro side of the equation. And so I think ultimately there’s some opportunities in terms of looking for a slightly cheaper euro over the course of the next couple of weeks as we continue to see European Central Bank discussing its own policy remit. But I think that also provides some opportunities to pick up some euros relatively cheaply, not necessarily against Sterling, but I think any dips in the euro against the US dollar also will provide value once we get through the year, once we get through the election process moving towards the end of the year.

Ian Pollick: Well, thank you for that, Jeremy. And with that, I want to say thank you for taking the time to be with us today. You are our resident expert on Brexit and all things sterling. We appreciate you taking the time. I hope you and your family are well during this difficult period for all of our listeners. Thank you very much for joining us this week. We’ll be back next week with Royce talking about the Canadian economy and Canadian rates markets. And remember, there were no bonds harmed in the making of this podcast.

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