GBP/USD should breakout after a Brexit trade deal but shorts will be tempted by risk: reward

Surprise surprise its December and there is no post-Brexit trade deal! Surely an agreement will be reached in the end BUT the risk: reward to taking the other side is interesting

 

Must know about GBP/USD

  • Sterling has dropped 1.5% on Monday after touching a 1-year high at 1.35 last week
  • “Significant differences remain” is still the way trade talks are being described with 3 weeks to go until December 31 when the transition period ends.
  • The sticking points are fisheries and ‘level playing field’ provisions, which are said to be most difficult because they involve ideological differences in view of Brexit
  • The assumption by many market participants is that a last minute deal will be struck
  • GBP/USD is at the top of a 2+ year trading range between 1.20 and 1.335. That means a downside move is less likely but also potentially much larger than any upside move

 

What’s happening with GBP/USD?

GBP/USD fell sharply on Monday after no EU/UK trade deal was reached over the weekend.

Brexit trade deal nerves kicking in at the final hurdle #GBPUSD

 

Brexit talks have ‘resumed’ again this week in what is being called a ‘final push’ to get a deal over the line before December 31. Lord David Frost is meeting his chief negotiating counterpart Michel Barnier while Prime Minister Boris Johnson is speaking with Ursula von der Leyen over the telephone. The two key sticking points are still fishing and business competition rules or so-called ‘level playing field’ provisions.

As a reminder, Brexit already happened in January, but the UK has been abiding by EU rules since as part of a transition to trading on its own terms, starting in 2021. The UK and EU are trying to reach a Free Trade Agreement (FTA) in order to trade tax free on certain goods. If there is no deal, it will mean border checks and taxes for goods traveling between the UK and EU.

The deadline is December 31, any deal needs to be turned into a legal text and translated into all EU languages, then ratified by the EU parliament and possibly all 27 member states before 31 December. The UK would enter legislation for British MPs to vote on. That means it’s a big week ahead because a deal really needs to be struck ASAP for it to happen in time.

The ‘Internal Market bill’ a UK law that aims to break some of the provisions of the Withdrawal agreement - the treaty agreed with the EU in January - will likely pass in the House of Commons Monday night. The Taxation (Post-transition Period) Bill also returns to the House this week.

The EU Leaders summit happens on Thursday (December 10th) and this is seen by many as the time at which a deal really needs to be in place.

 

Risk: Reward

The best investments tend to involve talking a relatively small risk for an outsized return. In the case of the cable rate (GBPUSD) the risks are quite well defined because of the trading range that the currency pair has been trading in for the best part of 2-years.

 

GBP/USD

 

The price ceiling is at 1.335 while the floor is at 1.20. 

The exchange rate is trading near the top of this range because the expected result is that a trade deal will be made. However, the breakout is not happening until the deal is inked. A price move up even as high as 1.36 will likely signal that a deal is done or so close that it is as good as done. The risk to this scenario is that prices are immediately marked up well beyond 1.36 as soon as a deal is agreed- but since a deal is the expected outcome, this seems less likely than the price being quickly marked down on no deal.

It’s probably fair to assume that volatility would be greatest to the downside were no deal to occur. It’s reasonable to think that GBP could move back to the bottom of its trading range near 1.20 were no deal to happen. Even if a deal looks unlikely but gets done at the very last minute, there could be some considerable downside risk in Sterling before it happens.

Whichever way it goes, there is likely be higher volatility. We can see that from the hedging bets being placed in options markets.

 

brexit risks

 

What will happen?

The rule of Brexit to date has been to expect the unexpected. In short, nobody knows but we can quickly summarise the reasons a deal might get done and reasons it might not:

Deal:

  1. A ‘fair’ trade deal is the optimal economic result for both the EU and UK
  2. The pandemic raises the economic importance of the UK/EU trading relationship for both sides
  3. EU doesn’t want to risk outcome of UK surviving and thriving in a no-deal scenario
  4. UK will compromise for deal because it would be worst hit short term from no deal
  5. No EU trade deal would quite likely mean no US trade deal under president-elect Biden

 

No Deal

  1. One side tries to use the weak economic position of the pandemic to squeeze the other side so the other walks away
  2. UK government can hide any effect of no deal in pandemic recession
  3. EU politically prefers no deal to UK being seen to be getting ‘preferential treatment’
  4. EU is trying to tie UK into its rules even after British voted to leave those rules
  5. UK politics of Boris Johnson’s ‘red wall’ demands a return of British sovereignty

 

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