(Reuters) – Sterling, shares in British banks and even German and Irish government bonds are among the financial assets most sensitive to Brexit developments as long-running negotiations on Britain’s departure from the European Union enter a crucial week.
The pound surged as much as 1.5% on Tuesday to a near five-month high of $1.28 after Bloomberg reported British and EU negotiators were close to a Brexit draft deal. (Full Story)
It gave up a large chunk of those gains on Wednesday as expectations of a last-minute agreement moderated.
The British currency enjoyed its best week since 2017 last week after Prime Minister Boris Johnson and Irish counterpart Leo Varadkar said they could see “a pathway” for an agreement for Britain to leave the EU by Oct. 31.
The two sides must clinch a deal before or during an EU summit on Oct. 17-18, which must then be approved by the British parliament.
While Brexit has cast a cloud over world markets since the June 2016 referendum resulted in a narrow win for Leave, some assets are particularly sensitive to headlines and will show an outsized reaction, whatever the outcome of the talks.
Following is a graphical tour of just what’s in play as the Brexit endgame plays out:
SILVER AND GILT
Sterling’s exchange rate has been by far the most sensitive price to Brexit news flow. Last week, optimism a deal can be reached drove the biggest two-day pound rise in over 10 years GBP=D3. A negotiated deal will likely send the pound into the “low 1.30s” against the U.S. dollar, JPMorgan says. UBS Wealth Management expects a rise to $1.35 GBP=D3. Reuters polls foresee sterling between $1.27-$1.34 if a hard Brexit is avoided but a “worst case” outcome of no-deal will see it between $1.10 and $1.19, the poll showed.
Two respondents predicted parity with the dollar.
Recent sterling gains rippled into derivatives markets, with one-month risk reversals GBP1MRR= — a ratio of bullish to bearish bets on sterling — flipping into positive territory for the first time this year and indicating a washout of negative bets. It has been positive only three times since the 2016 vote.
A sterling move up would also up-end excessive ‘short’ sterling bets on futures; Reuters calculations show net short bets for the pound are still nearly double their historical five-year average.
(GRAPHIC – Sterling rallies to 5-month high: https://fingfx.thomsonreuters.com/gfx/mkt/12/7407/7338/gbp.png)
(GRAPHIC – Sterling options: https://fingfx.thomsonreuters.com/gfx/mkt/12/7336/7267/options.png)
(GRAPHIC – GBP Positions: https://fingfx.thomsonreuters.com/gfx/mkt/12/7322/7253/GBP%20Positions.png)
HOME AND ABROAD
Some of the biggest winners from a Brexit deal will be shares in companies that earn their living from the UK economy. Unloved for years, an index of such shares soared on Friday, rising more than the blue-chip FTSE benchmark for the first time since May.
The index, compiled by JPMorgan and tracking about 30 stocks that make all or most of their revenue in the UK .JPDEUKDM, soared almost 8% for its best day since the grouping was created nearly three years ago. House builders such as Persimmon PSN.L and Barrett BDEV.L, as well as domestic banks Lloyds LLOY.L and Royal Bank of Scotland RBS.L, drove the rally.
Since May, the index has languished at a discount to the FTSE-100 as fears grew of a disorderly EU exit that would inflict huge damage on the British economy. The markdown widened after Johnson took over as prime minister.
On Friday, though, the index outshone the internationally focused FTSE 100 .FTSE by 4.4%. To put Friday’s moves into context, RBS’s 11% surge was its biggest move in either direction since June 24, 2016, the day after the referendum.
(GRAPHIC – UK domestically focused stocks vs exporters: https://fingfx.thomsonreuters.com/gfx/mkt/12/7403/7334/BREXIT.png)
(GRAPHIC – Brexit shocks and stock moves: https://fingfx.thomsonreuters.com/gfx/buzzifr/14/8467/8467/Pasted%20Imag…)
A no-deal outcome would likely force the Bank of England to cut interest rates to shore up the economy but last week’s optimism washed out money market bets on a rate cut in March. No cuts are now expected until December and a Brexit deal may dampen that possibility too. BOEWATCH
An orderly Brexit would also reduce pressure on the European Central Bank to cut interest rates and might also boost the euro. Money market futures have trimmed chances of an ECB cut in December to 20% from 40% early last week ECBWATCH.
(GRAPHIC – Britain yield curve: https://fingfx.thomsonreuters.com/gfx/mkt/12/7406/7337/Britain%20yield%2…)
BOND BULLS TAMED – OR NOT
Brexit clarity would go a long way to removing some of the entrenched pessimism that has swept a whole swathe of the euro zone government bond market into negative yield territory.
Brexit jitters have not only boosted demand for safe-haven German or U.S. debt but also fuelled economic growth worries in the bloc — the UK is Germany’s fifth largest export destination.
No wonder then that bond yields in Germany — viewed as a proxy for the euro area — have tracked sterling closely in recent months. Goldman Sachs predicts a near-term Brexit resolution could send British bond yields GB10YT=RR at least 20 basis points higher and push up German and U.S. Treasury yields by 10 bps and 5 bps respectively. (Full Story)
JPMorgan told clients its ‘overweight’ in euro zone debt would benefit from any Sino-U.S. trade deal as well as from a Brexit agreement.
(GRAPHIC – Germany’s 10-year bond yield vs Britain’s pound: https://fingfx.thomsonreuters.com/gfx/mkt/12/7324/7255/DEGBP1410.png)
WILL IRISH EYES BE SMILING?
No euro zone country has a higher stake in Brexit than Ireland. Not only is Britain Ireland’s largest trading partner but its border with the British province of Northern Ireland has been the thorniest issue in Brexit negotiations. A disorderly Brexit risks a return to the violence that plagued Northern Ireland for decades before a 1998 peace deal.
“One of the things you can observe is that when risks of no-deal Brexit rise, Ireland tends to underperform,” said Peter Schaffrik, global macro strategist at RBC Capital Markets.
The Irish government has pledged 1.2 billion euros to alleviate the effects of a no-deal Brexit, allowing its budget to go into deficit. No wonder then that Friday’s positive Brexit noises pushed its 10-year government bond yields 10 bps lower. Its spread over Germany — effectively the yield premium investors demand to hold Irish debt — is at 144 bps, the tightest since late July DE10IE10=RR.
Irish stocks likewise jumped 4% on Friday with bank shares rising as much as 11%.
(GRAPHIC – Spread between Irish and German bonds: https://fingfx.thomsonreuters.com/gfx/mkt/12/7398/7329/Spread%20between%…)
(GRAPHIC – Irish shares: https://fingfx.thomsonreuters.com/gfx/mkt/12/7410/7341/ireland.png)
Brexit will reverberate in eastern Europe too. With 900,000 nationals living in the UK, Poles are Britain’s biggest immigrant group, sending home a billion euros a year in remittances. Britain is also Poland’s second-biggest export market — Warsaw runs an annual trade surplus with the UK of just over 8 billion euros.
No wonder the zloty plunged as much as 4.7% against the euro and 9 per cent against the dollar on the day after the referendum.
Hungary and the Czech Republic are exposed to British demand for vehicles, with 0.2% and 0.35 of their respective GDP linked to ‘value added’ exports to the UK, ING Bank calculated late last year.
The longer-term threat is what Brexit means for the 2021-27 EU budget. Britain contributes around 6 percent of the budget and its departure will see average EU GDP per capita levels decline. That will push incomes in Poland, the Czech Republic and Hungary above the EU average and may spell cuts to their funding.
(GRAPHIC – Europe’s economic dependency on the UK: https://fingfx.thomsonreuters.com/gfx/mkt/12/7329/7260/Pasted%20Image.jpg)
(Reporting by Saikat Chatterjee, Dhara Ranasinghe, Josephine Mason, Marc Jones and Thyagaraju Adinarayan; Compiled by Sujata Rao; Editing by Catherine Evans)