Life in a post-Brexit world: What's next for the UK?
The commemorative coins have been minted and the tea towels printed to mark Brexit Day. At 11pm GMT today, the UK leaves the European Union (EU) and enters a transition period until the end of 2020. After today, Britain will not be able to reverse the formal process of exiting the EU by revoking article 50. In that sense, Brexit is final.
In many other ways, however, we are only at the beginning of a lengthy negotiation process with outcomes still uncertain and another potential cliff-edge on December 31, 2020. In this blog, our currency expert, Van Luu, looks at possible scenarios and likely market implications from here on.
Will we see any financial market volatility today?
From our point of view, financial markets have fully digested the December UK general election, the passing of the withdrawal bill and Britain’s certain exit from the EU. We probably won’t be seeing any Brexit-induced market volatility today as we approach the time of departure. During the 11-month transition period that starts at 11pm on January 31, the UK is staying in the single market and the customs union. The British public will not notice any changes in their everyday lives the following day. However, equity, bond and foreign exchange markets are rightly focused on the future trading relationships that will take shape between now and the end of the year.
How will negotiations over the future relationship play out?
In practice, negotiations between the EU and the UK are not starting before early March. The EU countries will take four weeks to establish their negotiation objectives and will have these signed off on February 25, 2020. Formal talks will only begin afterwards, however, many constitutional and trade experts regard the remaining time frame as too short for working out a comprehensive trade agreement. The Institute for Government believes that both sides will aim for a goods-only free trade deal by the end of 2020 and leave talks about services and other thorny issues until 2021.
Under the withdrawal agreement, Prime Minister Boris Johnson can ask the EU before July 1, 2020 for an extension of the transition period for one or two years. The government has ruled out such an extension in its domestic withdrawal bill. However, it could repeal the no extension clause if push comes to shove. This would give both sides more time to agree to a wider-reaching trade deal. Depending on how much political capital the government has by the summer, we can see the Prime Minister reversing course on the no extension stance.
What happens if there is no agreement by the end of 2020?
If there is no agreement by the end of 2020, the implications may be similar to what happened in the wake of the no-deal votes by the UK Parliament in March and October 2019. Unlike previous no-deal scenarios, citizens’ rights are protected, the divorce bill would be honoured, and an arrangement for goods trade in Northern Ireland has been decided. However, no agreement on the future relationship would have similar adverse consequences for trade between the UK and the EU, as in previous no-deal scenarios.
Because the economic consequences of no deal are dire for both sides, the most likely scenarios are that:
- The UK and the EU will agree to a limited goods-only trade deal by end-2020, or
- Britain will seek an extension of the transition period.
To be sure, if the UK government changes its mind and seeks a transition extension after July 1, 2020, the EU may not acquiesce. Based on prior experience from the Greek crisis in 2011-12 and the Brexit negotiations in 2016-2020, the door is never completely shut when it comes to the EU. The prime minister and the EU have precedent when it comes to making concessions and performing U-turns, rather than risk parting ways without a deal.
What about the Bank of England?
The Bank of England left interest rates unchanged on January 30. While two policymakers voted for a cut, the majority of the seven members were sufficiently encouraged by the recent pickup in economic sentiment indicators to keep the bank rate at 0.75%. Easier monetary policy is not off the table, and will depend very much on whether hard economic data will follow the confidence bounce that is visible in the surveys. Trade negotiations are key to whether economic activity will recover.
We still see gradual upside for the pound vs the U.S. dollar from current levels.
The pound (GBP) exchange rate is the cleanest barometer of Brexit sentiment in markets, while UK bonds and equities are often influenced by global forces. According to our Cycle-Value-Sentiment framework, the pound is undervalued vs. the U.S. dollar and has the potential to strengthen against the greenback. Between now and the favourable year-end outcome we expect for the pound, there are bound to be many twists and turns in the negotiations and plenty of volatility in the GBP/USD exchange rate.