Trading Week: crunch time for Brexit, is it time to be a pound contrarian?

Economic data is fairly thin on the ground this week, which allows politics to dominate European markets. There is really only one show that traders need front row seats for: Brexit. With a mere 18 days until the UK is scheduled to exit the European Union, the stakes are high, the markets are jittery and the headline risks immense.

Theresa’s May’s final act, or is it?

On Tuesday the British Prime Minister is scheduled to hold a second, and supposedly final, vote on her exit deal between the UK and the European Union. The first vote in January saw Parliament reject the deal outright (432 votes against the deal vs. 202 in favour), we will have to see if the scaremongering over a no-deal Brexit has worked and persuaded the hard-line Bexiteers’ to finally vote in favour of May’s deal. According to the British Sunday papers, this group may vote with May, however it is likely to come at a high personal cost: her job. Thus, if Mrs May loses this deal on Tuesday she will have very little choice but to walk away from 10 Downing Street, however, if she wins the vote then her days at the top may also be numbered. 

After a strong start to the year, the pound dwindled at the end of last week, as the market’s patience with Westminster started to wane. GBP/USD slipped towards $1.30, although this pair has picked up slightly early at the start of a new trading week, traders may wait on the side-lines, with the real moves for sterling coming once we know the result of May’s Brexit vote.

Does this vote really matter?

What are the stakes? We believe that if the Prime Minister wins a strong majority on Tuesday then the pound may rally hard, as it would mean that the UK is definitely leaving the EU with the much-touted deal. However, it is highly unlikely that the Brexiteers’ are going to let May’s ride be that easy. Thus traders’ need to consider the prospect of May losing Tuesday’s vote, and what that may mean for the pound and where the Brexit process goes next.

Why traders shouldn’t fear the worst

Although the media is portraying this vote as crunch time in the Brexit process, and a tipping point between an orderly exit and a chaotic one, traders should not get too caught up with the media noise. In our view, there are three things that could assuage markets in the short-term. Firstly, Theresa May might delay the vote at the last moment, if she is worried that she may lose. This would kick the can down the road, but it could give her precious days and hours to come up with a more acceptable solution to Brexit for the majority of Parliament. Secondly, even if Parliament rejects the deal, this is not confirmation that the UK will leave the EU without a deal. The final discussions are set to take place on March 20-21, which leaves just enough time to schedule another vote and get the UK the deal that many believe it needs to leave the EU in an economically safe manner. Lastly, if Parliament rejects the deal for the second time, then this will likely mean that Article 50 will be delayed until June, kicking the can even further down the road.

Why a delay until June could be good for markets

The prospect of delaying the Brexit process until June might be a temporary boon to UK asset prices. If you can imagine the Brexit process as a call option on the UK economy, then extension to the time value, and the higher probability that this would give to the Prime Minister of finding a deal with the EU before the UK leaves the bloc, would see the value of the call option rise. Thus, even if we don’t get a decisive solution to Brexit from this week’s vote, and even if we get a second rejection of Mrs May’s deal, all hope is not lost for sterling, see below for our pound focus.

Does anyone care about the spring statement?

There may never have been a less anticipated spring statement from the UK Chancellor in the history of all spring statements. Phillip Hammond is due to deliver his Spring Statement on Wednesday, hours after the Commons vote. However, how can he deliver a clear message about the UK’s economic prospects and the government’s tax and spend plans with the uncertainty of Brexit hanging over Westminster? Thus, we see this week’s speech as a damp squib, the actual budget later this year is far more important, and we doubt it will have much impact on the pound as Brexit continues to dominate the direction of sterling.

What next for volatility?

Has December’s volatility returned to financial markets? Global stocks had their worst week of the year so far last week as fears about global growth dominated. But all is not lost. Central bankers’ are once again starting to act like the financial markets’ crack dealers. The ECB offered banks another round of cheap funding on Thursday, by starting its TLTRO- 3 programme. This sent the euro tumbling and the dollar index rushing to its highest level of the year. However, dollar bulls beware. If the February jobs report is a sign that the US economy is starting to waiver, then the Federal Reserve has the most room to cut interest rates compared to the other major central banks, which could send the greenback tumbling. Watch out for Fed chairman Powell’s speech late Monday night/ early Tuesday morning. If he continues to sound dovish on the US economy then the markets may price in a potential reversal in Fed policy by the end of this year. A decline back to 96.80 for the dollar index– Thursday’s low - could be on the cards as we start this week. See below for our S&P 500 focus.

Pound focus:

This is undoubtedly a big week for the pound, and even though the prospect of a rejection of May’s deal is a possibility, we remain mildly optimistic about the pound’s prospects in the short-term. Firstly, 1.2990 is a key support zone and the 61.8% retracement of the pound’s recent rally. Added to this, there are various reports that US hedge funds are starting to back the pound again, and there was a further reduction in net short GBP positions last week to -34.9k, vs. -47.5k the previous week, according to the latest CFTC data. We would expect volatility in pound crosses to rise as we get the result of Tuesday’s vote, however, this may not last long, particularly if the Brexit process is delayed until June. However, a decisive break of 1.2990 in GBP/USD, could see some temporary selling back to the 1.2890 level, a resting place during the February rally. However, we could see GBP/USD hurtle back above $1.30, towards $1.3190, a key resistance zone, and then back towards $1.35 if Parliament votes in favour of Theresa May’s deal on Tuesday.

Stock focus 

The S&P 500 is also in focus this week, after a torrid performance in recent days. The question now is, will it continue to fall, or can it bounce back from these lows? We continue to believe that central bankers will save the day, volatility will drop and stocks will bounce back with a few calming words from Fed chairman Powell this week. Added to this, we started to see some small buying interest in the S&P 500 at the end of last week and volatility start to fall. The decline in the S&P 500 last week was less than 100 points, this move didn’t break any key support areas or fall low enough to make us worried that this year’s gains are at risk. Instead, we believe that this is a healthy pullback, and bargain hunters could help to buoy this index back to the late February highs. This doesn’t take away from our general fear that markets are too addicted to central bank stimulus, and one day the well will run dry. However, we are not at that point yet, so, on balance we expect to see a recovery in the S&P 500 next week.