Looking at the British pound today, concerns regarding Brexit and the stock market rout are outweighing the Bank of England’s positive economic outlook. As a currency that benefits from rising risk appetite, pound sterling has been selling off sharply in February thanks to fears regarding elevated asset prices. While Bank of England Governor Mark Carney helped the pound last Thursday after saying "it is likely to be necessary to raise interest rates", the rebound was brief. As we wrote in this morning’s British pound daily update, the EU’s chief Brexit negotiator (Michael Barnier) suggested that negotiations have been contentious. Specifically, a post-Brexit deal was “not a given” and the UK has raised “substantial” objections to the EU’s transition deal terms. While the pound has been weak in recent times, we argue that the longer-term pound rally is set to continue. Beyond drivers that we highlighted in late January, a Brexit transition deal remains likely despite Barnier’s latest comments.

Michael Barnier raises the stakes

As the clock ticks towards March 2019, the UK clearly does not have enough time to negotiate a comprehensive post-Brexit trade agreement. As any Brexit deal will ultimately require a parliamentary vote, a disruptive Brexit is unlikely to gain support from UK lawmakers. Furthermore, Theresa May has made it clear that she is looking to deliver a “smooth and orderly” exit from the EU. This means the UK is not seriously considering a “hard Brexit” scenario and reverting to trading rules governed by the WTO. This weakens the country’s bargaining position against the EU as a result. Barnier’s comments, given this context, are not entirely surprising.

While the UK has been reluctant to accept transition deal terms (particularly those relating to immigration and the jurisdiction of European Court of Justice), we argue that the country has few options given this dynamic. Instead, it is more likely that May will ultimately concede and accept most of the terms dictated by the EU. In the short-term, news headlines relating to the negotiations will dampen the pound rally. Political infighting within the Conservative Party is also likely to increase as anti-EU members protest new concessions. Similar to what transpired last year, the pace of negotiations is likely to remain disappointing until the upcoming EU leaders summit in late March. Once the two sides make progress towards a transition deal, the pound can resume strengthening.    

Future rate hikes dependent on smooth Brexit talks

Another factor to consider is that the Bank of England is unlikely to raise rates if trade negotiations remain highly uncertain. While Carney did not directly address this scenario last week, it is unlikely that the BoE will seriously consider raising rates if trade negotiations remain contentious. For now, reasonably good economic data and monetary tightening in other developed markets is driving the Bank of England’s shift in policy. This may change if Brexit negotiations become more acrimonious over time.  

Brexit still a significant risk

All in all, Brexit negotiations remain a key risk for the pound. While there are many reasons for the currency to continue rallying, limited progress in negotiating a transition deal will ultimately weigh on the pound. Given the requirement for Parliament to vote on any Brexit deal, the probability of a “hard Brexit” outcome remains relatively remote. It is far more likely that Theresa May will ultimately concede to most of the EU’s demands. While this will facilitate a “smooth and orderly” exit, she is likely to pay a steep political price as a result. While our view on the pound has been consistently bullish, the politics surrounding Brexit is the biggest risk to our outlook.