Bust a deal and face the Wheel

Welcome to the Thunderdome is where things stand for Brexit and UK financial markets. The EU has struck a revised deal with Boris Johnson, and now the UK prime minister faces the considerable challenge of getting it passed by parliament at a special sitting on Saturday.

Passing the revised deal looks tough as the Democratic Unionist party, led by Arlene Foster, has said no dice, Mr Johnson, “as things stand”. It’s also doubtful that summoning inspiration from Dexys Midnight Runners and humming “come on Arlene” will win the day.

The FT’s Robert Shrimsley dissects the deal here, where he makes the point that while Mr Johnson will claim to have met his pledge to “get Brexit done”, the process of Brexit will only just be getting started should the deal pass parliament.

The troubling Westminster arithmetic duly prompted a reversal in market sentiment on Thursday, leaving the pound a touch lower (after it neared $1.30 on Thursday morning in London). The domestic equity-dominated FTSE 250 index closed up 0.2 per cent, having earlier risen 1.3 per cent to its highest level since the start of October in 2018. Gilt yields also fell after an initial rise on Thursday. The policy sensitive two-year yield sharply reversed from an intraday peak of 0.62 per cent back to just under 0.5 per cent. Bank of England cuts beckon is the message here. A 10-year gilt yielding 0.67 per cent remains under the BoE’s base rate.

Still, there is an air of relief as the long-dreaded threat of a no-deal Brexit looks far less likely. Dean Turner at UBS Global Wealth Management says:

“The outcome that investors feared the most, a no-deal Brexit, seems less likely now than at any time in the last few months.”

From a trading perspective, expect little let up in market volatility, particularly for the pound. Positioning flows on Thursday in the currency options space indicate for the next one- and three-month periods, investors and others are favouring a lot more downside protection in case the pound tumbles from here. These so-called risk-reversal measures reveal a shift towards the buying of put options that become profitable for holders should the spot rate for the pound slide.

Having turned positive a week ago, the one-month risk reversal for sterling has dropped sharply below zero in the past 24 hours. Since the June 2016 referendum resulted in a vote for the UK to leave the EU, investors have been so bearish on the pound that the cost of buying currency puts has generally been greater than that of calls. This is highlighted by a negative risk reversal, as shown below:

Of note is how the three-month risk reversal has remained camped in negative territory, highlighting how, for all the brimming optimism that drove the pound sharply higher over the past week versus the dollar and the euro, doubts have loitered with intent about a deal passing Westminster.

Fred Cleary at Pegasus Capital alerted me to this development and says:

“The spot move is looking more like a short squeeze (similar to the Jan move as [a] deal was being agreed and presented for voting) and [I] can only assume there are still lingering concerns over election/no-deal/second referendum.”

Indeed, the failure of this deal to pass parliament on Saturday opens the door to a general election where Mr Johnson will probably campaign on his deal.

Further Brexit uncertainty will contain the animal spirits of markets. But should parliament muster a majority for the revised Brexit deal — it looks like Boris is anywhere from seven to 20 votes short of getting the deal passed, according to betting sites — the door opens to a transition period that results in further negotiations over the UK’s trade relations with the continent.

There’s also the long-term consequences of a Boris Brexit, seen as constituting a harder exit from the EU that clips the economy’s wings. On that topic, the FT’s Chris Giles lays out the economic harm here.

Still, averting a no-deal Brexit counts for something for the foreign exchange market. George Saravelos at Deutsche Bank reckons the ground has shifted to a more bullish view on the pound. He notes:

“The important point from the market’s perspective is that avenues to a no-deal Brexit have been largely closed off. The only prospect of a no-deal Brexit in the next three to six months would arise if a general election resulted in the Brexit party performing sufficiently strongly to be needed to support a Conservative minority government — this we consider to be a low probability outcome.”

And the scope of how far the pound can rally from here is highlighted by Dhaval Joshi at BCA Research via comparing dual-listed companies (Carnival and BHP are the examples and are quoted in London as well as New York and Sydney, respectively).

Dhaval says:

“The message from the dual listings of Carnival and BHP is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40.”

BCA notes how Carnival trades at a higher valuation in New York versus London, reflecting market expectations that “its mixed currency earnings” will appreciate more in dollar terms than in pound terms. In Sydney, BHP shares have a higher valuation “compared to their London listing” and this “valuation differential” reflects expectations of the pound appreciating “versus the Australian dollar to around A$2”.

So all eyes turn to Saturday and Westminster.

Marc Ostwald at ADM Investor Services speaks for many when he notes Thursday’s “‘deal’ is at most the ‘end of the beginning’” and reminds us that “Sunday night Asia FX trade for the GBP looks to be a recipe for some big gaps . . . and more volatility”.

Programming note

Market Forces is taking a break on Friday and returns next week.

Quick Hits — What’s on the markets radar

A potential turning point for emerging market equities is flashing as a 20-month downtrend has been broken, according to Christopher Dembik at Saxo Bank.

What sustains this shift is Saxo’s “central macro scenario” whereby “higher central bank liquidity combined with improving US and China credit impulses will start to positively fuel economic growth in Q1-Q2 2020”. A weaker US dollar is also required and here Saxo reckon “idiosyncratic US political risk ahead of the 2020 election will push the USD lower”.

One to watch particularly as the S&P 500 index seeks a new record high as the current earnings season picks up.