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Hard, Clean, whatever you want to call it, we’re out #Brexit

Surely now, surely, the conversation will move on from “Hard” vs “Soft”. From Supreme Court rulings. From Remainer Hope vs Leaver Disaster. It’s going to happen. The UK is leaving the EU. It therefore has to leave the institutions of the EU, all of them. The single market, the customs union, the ECJ. It then has to re-draw its own relationship with the EU and with the rest of the world. Leaving the single market doesn’t mean failing to achieve single market access; leaving the customs union doesn’t mean failing to trade with anyone in the EU, ever. Leaving the ECJ might be the poison pill in what starts off in any negotiation as the toughest position. “Yes we are off, we are prepared to create new deals, but the body that rules over all of you, won’t rule over all of us in our engagement with you”.

In fact this final point means that the real risk now is not hard/soft/clean/grey….. but orderly vs disorderly. Yes, the exit negotiations can take up to 2 years. But what if the UK just says it’s out, and provokes the EU to stop it? What if the EU says we can negotiate with you, but not if you’re never going to accept the European Court of Justice oversight, so the deal is off? Who sues who in this divorce? And more importantly, who would be the judge that divides up the assets?

Not to mention that we now have Trump telling us that leaving the EU is a “great idea” and that “I believe others will leave”. Oh and that for a UK trade deal, “We’re gonna get something done very quickly”. This is a man who has torn up the rule book already and he’s not even in power yet. He’s called up Taiwan. He’s talking to Russia. He’s not taking questions at press conferences, doesn’t believe his intelligence services, and he won’t be bound by ‘protocol’. Not to mention that he likes deals, and he likes winning. Will he wait 2 years before he can even start talking to the UK about America’s trade deal? Will he wait 2 months?!

And what about the chance of a Le Pen victory in France? If Britain is making progress on a trade deal with the most important nation in the world, is that not grist to her mill of France leaving the EU? OK, you say there’s less than 40% chance she wins… but that’s still a 40% chance that one of the biggest negotiating partners within the EU wants to tear up the allegedly straightforward post-Article 50 exit process itself! Meanwhile Trump wants to slap a 35% tax on BMW if they attempt to export their cars from Mexico. It would be to his benefit if the EU self-immolates over a disorderly Brexit, as he would have even more power over them.

[Of course, we should also recognise that he wouldn’t want the UK getting too strong either, so at some stage he would then threaten to strike a better trade deal with Germany than Britain, for example….]

The point here is that trying to trade this as a simple mathematical equation isn’t going to work. Just today, Blonde Money was told that the leaks over the weekend about May’s speech showed that “immigration > single market access”. As Thatcher would say, No, No, No.

If we really did try to write this as an equation we would end up in the fourth dimension. The market now sits here and waits for what May reveals in her speech. But her speech is not designed for the market. The line that Tory MPs have already been told to take is “The country is coming together”. This suggests that her speech is designed to be Prime Ministerial, re-setting the narrative, and forcing the House of Lords to put up or shut up when they come to pass Article 50. No doubt this is why the speech has been set for a few days before the Supreme Court ruling is expected. This means that if anyone in the market is expecting more details, they must surely be disappointed. This speech is not aimed at us. It’s aimed at reassuring her detractors she has a plan, and at forcing Parliament to do her will. If anything, Cable doing just 2 big figs overnight rather than the 7  of the October flash crash will strengthen her hand. No need to fear a calamitous currency drop – which anyway doesn’t (yet?) seem to be causing any harm, nor indeed does it really bother the government.

More significant therefore could be Carney’s hastily-called speech tonight on “Policy Issues Affecting the Bank of England”. Is this him trying to head off criticism at the pass – now that the declining pound, plus his extra rate cut and QE, are stoking inflation?

Either way, there is now a significant risk premium that needs to be built into GBP… if he was going to take back the rate cut and QE, is that really good for the currency to have such an unreliable boyfriend in charge??

GBP teeters on the edge

Towards the end of last year, Blondemoney attended a conference. The attendees were asked, what’s the big risk you’re worried about next year? 47% said Europe/EU elections; 26% said new US administration. Almost at the very bottom of the list, with just 2% of votes, was Brexit. At the time, that seemed complacent. Now, with Article 50 to be triggered in less than 11 weeks – and in fact with the trigger almost certainly a done deal – it seems downright dangerous to have forgotten about it. After all, GBP managed to shed several big figures in the day of the 7th October flash crash. There’s lots of chatter today about GBP/USD teetering on the edge of 30 year lows around 1.2090 – but then it managed to print below 1.1500 in a heartbeat on no news back then. The BOE are still trying to figure out what happened then…. perhaps by the time they issue the report GBP/USD will have already had a look towards parity! In any case, at some stage this year, with huge chunky and as-yet-misunderstood risks across the spectrum, it looks likely that a new all-time low in GBP is a scenario that needs to be on everyone’s radar.

At the moment, the short-term market is very short of GBP and keen to get shorter. Check out how GBP dipped yesterday on the mere announcement that Theresa May would be holding a speech next week on Brexit. That was good for 50 pts alone when it came out yesterday afternoon:

Cable 13 Jan 2017

Today’s turn higher can be attributed to those short-term guys taking some profits ahead of US holiday on Monday. But overall there is a sense that if GBP were to reach 1.25+ then it would be time to sell it again. Why are people waiting? Because of the worry that there’s no catalyst to plough new lows. The flash crash is written off as “bad liquidity in Asian time“; the better UK data since the Brexit vote is also upsetting the dynamic. Most of the market appear to be Remainers: as soon as the Government lost the first round of the court case that demanded recourse to Parliament before Article 50 is triggered, GBP rallied. There seems to be a desperation to cling onto hope of a ‘soft’ Brexit. As if ‘soft’ means anything at all. We don’t know what Brexit could/would/should look like, so how can we explain which is good/bad for the UK. Markets desperately want this to be a “cut-interest-rates-good / raise-interest-rates-bad” Snowballian kind of story. That makes it easier for them to quantify and understand. Indeed HSBC have even created a “Brexometer” to derive how hard/soft Brexit will be, based on the pound:

hsbc brexometer

oh dear oh dear. So, we take the pound lower if we fear hard Brexit and we can derive probabilities of a hard Brexit from a soft pound?

This is lunacy.

All we need to know is, can GBP go lower right now? Yes.

Will Theresa May tell all next week? No. Her speech is most likely just to ensure she wins the parliamentary and then House of Lords vote on Article 50. Which she will, or there will be riots on the streets.

Sounds like sell the rumour, buy the fact…

Think!

Thus far in 2017, the main questions occupying people’s minds seem to be:

– How many hikes will Fed do, and will BOJ or ECB be the biggest doves?

– How big a fiscal stimulus will Trump and Congress pass?

– How much reflation will the world have?

– Le Pen won’t really win but how much do we still hate the Euro anyway?

– Is China or Turkey or Russia or Mexico going to be the exponentially bad but not contagious EM this year?

Thats absolutely lovely. It really is. They’re good questions. But, my friends, they don’t even scrape the surface of what matters this year. They’re you, of 2 or 3 years ago. They’re flared trousers. They’re pineapples on sticks. They’re at Abigail’s Party. Parochial and unbecoming of a wonderful BM reader like you.

No, as we can see from allegations today that Russia may be able (already has?) enough information to blackmail Trump, these are the questions you need to be thinking of:

– When the trade war starts, who wins and loses?

– When does reflation turn into bad stagflation?

– When will Russia annexe another country and will it start with the Middle East or the Baltics?

– What will Le Pen do when she wins and how will the EU reform itself?

– When will Trump sack half his cabinet and when could he be impeached?

– When will investor exodus from years-long held positions turn into a rout as they realise they don’t know what their risks are and they don’t know how to measure these new risks anyway?

This doesn’t mean these things are going to happen. But it means they’re possible. They’re not zero percent. In some cases they’re even a 50% chance. (Le Pen in particular, given it’s a two horse race).

And the one we can be most certain of is the final question. Forget monetary policy. Forget an EM blow up. Investments are about to blow up, because we have spent decades trying to quantify and master risk: only to find that we are now entering a period where there is no such thing as the unthinkable. No black swans. No distribution of outcomes. No quantifiable probabilities. Just stuff happening. The messy business of humanity.

So today’s Trump report should be the first of many reminders that we have no idea how this Presidency will run. That oil could be $100 or $10, if Putin gained (more?) control of the Middle East. That you need to consider more scenarios than you ever thought possible. You’re going to need to be the most sceptical of your portfolios that you’ve ever been. And ready to think. Fast.

Positioning vs Reality

We are poised to enter one of those potentially confusing periods of Positioning vs Reality. The reality is that yes, the world is in an upswing higher, and was already before the alleged Trump Trades were put on:

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Inflation is back, baby, and you better believe it – with China’s Producer Price Index roaring up to 5 year highs at 5.5%, having been at -5% just 12 months ago….And yes, the rate of change in this inflation in China is the highest it has ever been:

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But then oh dear, what do we have here? Record net shorts on the US 10year:

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And the shortest Yen positions in a couple of years:

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Uh oh. Mind the gap in USD/JPY?

Patience. Just another virtue markets fail to have.

They say markets don’t like uncertainty, but it’s better characterised as the unknown. Given that each price everywhere is always an ongoing discount of all future information, difficulties arise when that “future information” looks a bit shaky. That’s why they love anything that can be quantified: inflation data, central bank comments about hiking or cutting, commodity prices, etc. But why they hate anything as messy as a human personality: a politician, or an election, or a company suddenly firing its chief executive. There has been a few sticky patches over the past few years, with central bankers wading into forward guidance, but given that the response always became “lower-for-longer”, there was no need to bother with nuance any more. Indeed even the ECB and BOJ’s latest policies became so complicated that it was easier just to earmark them as “business as usual, lower-for-longer”, rather than look into how each of them is trying to extricate themselves from that exact policy.

Well 2017 is about to be a masterclass for the markets in managing the unknown. Falling back on old heuristics is going to be painful. It’s not #FOMO but #FOTU, as regular readers already know. And if you thought that Trump’s Tweets already have the market on guard… what are we to make of the Brexit negotiations?

It seems obvious to point out that Theresa May is the antithesis of Donald Trump – but what’s more important for investors is how their opposing methods of communication will both rile market price discovery. Trump shoots from the hip, meaning we don’t know timing, but we do know the general direction of the comment (slap down any US company trying to invest overseas/slap down China/cheerlead for Russia). Theresa May is the opposite – biding her time, but also keeping direction close to her chest.

Argh! For the market, this feels like the worst of both worlds. Too slow to provide an answer, and too coy to provide the chance to assess a range of outcomes. Last week’s Economist front page is grist to the mill:

theresa-maybe

Is it indecision? Or just a classic poker game? In a multi-dimensional poker game with many players, not least her own cabinet, her own party, her voters, the electorate at large and most specifically the 52% who voted to leave…. oh and that’s before we look at the who’s on the other side of the negotiating table: 27 different countries, of whom 2 of the biggest will likely change their negotiating stance within the next 9 months (due to elections).

Of course, it would be nice to know that Brexit will lead to “x”, and then markets can work backwards from there. But that’s hugely unrealistic, and, Blondemoney would wager, rather unfair. However until markets accept that, GBP and UK assets will no doubt get punished for this ‘uncertainty premium’. Which is really just an inability to appreciate that the unknown, in all its messy unpredictable glory, exists. Patience, friends, patience…