Market Insights

No Surrender! Oh, wait…

And so, an agreement is reached, to move onto talking about an agreement, which might never be agreed. Here’s the lowdown on today’s agreement that the UK has made ‘sufficient progress’ to move onto Phase 2 Trade Talks with the EU:

  • NI/RoI will retain soft border
  • ECJ will have a say over the rights of EU Citizens in the UK for 8 years
  • The UK will continue to pay almost all of its EU liabilities as of 31 Dec 2020 as they come due
  • …But only if there’s a deal at the end of the entire negotiation process

Reaction:

  • Conservative MPs so far falling over themselves to praise Theresa May, including BoGoveJo as are the EU, with Barnier and Juncker keen to explain the agreement was reached through TM’s “personal” hard work
  • Senior Diplomats, such as Christopher Meyer, congratulating PM on getting an agreement done
  • Republic of Ireland PM Varadkar is happy: “We have achieved all that we set out to achieve”
  • DUP leader Foster not so happy, arguing, ‘We cautioned the prime minister about proceeding with this agreement in its present form given the issues which still need to be resolved and the views expressed to us by many of her own party colleagues‘, but happy to have a separate document with Six “clear commitments” from the UK government that NI’s position in the UK would always be safeguarded
  • Remainers unhappy that this finally means Article 50 won’t be revoked, but happy that it might end up looking like a softer Brexit due to soft Irish border
  • Brexiteers unhappy about the soft border and role for the ECJ, as well as TM ‘rolling over’ to meet EU demands, particularly on the ~50bn divorce bill; but grudgingly admit they can’t argue too much against the document as it does still provide room for “No Deal”

With all sides slightly unhappy, this suggests a decent consensus has been forged. On balance, the Brexiteers are less happy, suggesting this is indeed a victory for the “softer” side of Brexit. The RoI/NI spat over the border is just the entire Brexit question in microcosm, and it hasn’t really been resolved. But Leo is happier than Arlene.

This means Brexiteer protests will increase in the next stage, with the clock loudly ticking. Indeed, the document means something has now changed on the “No Deal” front, with paragraph 49 the key:

The highlighted sentence appears to say that if there is No Deal, then the UK (not just Northern Ireland) will maintain ‘full alignment’ with the Single Market and the Customs Union. Now, the second half of the sentence qualifies that it’s full alignment only where those rules “support” the island of Ireland. This is clearly a sop to both the Republic and to NI, that they don’t need to worry, whatever happens. But it may become a noose around the neck of No Deal because it means the SM and CU will exist as a baseline.

As one of Ireland’s political commentators put it it, it’s currently a Schrodinger’s Brexit:

Of course, all of this can be fudged and re-worked. It may lead to a hybrid Customs Union for the UK (like Turkey’s relationship with the EU).

In reality, the only question is this: Can Theresa sell this to the country? 

The spin machine is going into overdrive, with the Conservative Party briefing notes on the deal emphasising how it works for everyone but “nothing is agreed until everything is agreed”:

‘This agreement secures the rights of the three million EU citizens living here and the million British citizens living in the EU, represents a fair settlement of the accounts and maintains the Common Travel Area with Ireland, which has operated since the 1920s, and sets out both sides’ determination to avoid a hard border between Northern Ireland and Ireland, while respecting the integrity of the UK Single Market.

…This is a good deal for citizens, for taxpayers and for all parts of the United Kingdom that will allow us to get on to the vital trade negotiations and get quick agreement to an implementation period in the best interests of people and businesses in the UK and across the continent as we leave EU. While we have reached agreement on the phase one issues, paragraph five of the report makes it clear that ‘nothing is agreed until everything is agreed’.

So we’ve agreed something that works for everyone, but we can always walk away.

A masterclass in spin.

The public will need more than an arcane meta interpretation of a buried paragraph to get upset at today’s document.

Can the Conservative Party now hold the line? In the short term, yes. This staves off the Corbyn threat, and after a trouble-free Budget, there is now a little bit of positive momentum for the government. Even Nigel Farage is left only to say we move onto the ‘next stage of the humiliation’. The Brexiteers will eventually find their killer argument, but it will likely take the next stage of talks to reveal it. All clear on the western front into the end of the year then.

 

 

Can (Northern) Ireland derail Brexit?

++ The BM Lowdown on the current Brexit flashpoint:
Either: The people of Northern Ireland accept a hard border.
Or: The UK government accept the entire UK remains in the EU Customs Union (like Turkey, without free movement of labour).
Ultimately, the UK government does not fall ++

As expected, the island of Ireland has indeed become the thorn in Brexit’s side. The DUP were unable to accept the text of the agreement, not least because they didn’t receive sight of it until the last minute. Arlene Foster has always been clear that Northern Ireland would prefer a soft border. She wrote a joint letter to that effect with then-Deputy First Minister Martin McGuinness in the aftermath of the Brexit vote last summer, noting:

Northern Ireland had just voted to Remain in the EU, by 56%. Since then, the Unionist parties lost their majority in the recent NI Assembly election for the first time ever. Our correspondent BallyMoney points out that in the first Northern Ireland parliament of 1921, Unionists won 67% of the vote. In the first NI Assembly election, of 108 seats, 58 went to Unionists. Since then their share has been falling as support for Nationalists rose:

It’s no wonder Arlene took the soft border position. She has two constituencies: the whole of NI, and the Unionists. She will, however, always prioritise the unionists. Not for nothing is their war cry “No surrender”.

What are the positions of the other key players?

  • Theresa May needs to show “sufficient progress” in order to move onto the much-cherished sunlit uplands of trade talks by getting sign off from the EU at the European Council meeting on 14/15 Dec.
  • The UK Cabinet each have their own positions on Brexit, from Hard Brexiteer Beast BoGoveJo, to Soft Remainer Pragmatists like Spreadsheet Phil Hammond. But they are all united in their desire to remain in government and keep out Corbyn.
  • The Irish Prime Minister and the EU are united in extracting as much from the UK as possible while Theresa is desperate to move on.
  • The Republic of Ireland wants a soft border for economic and constitutional reasons
  • The DUP is adamant about remaining integral to the UK rather than moving closer to Ireland (and by association the EU).

So Theresa needs progress, and the EU have decided that means a solution to the Irish border. But Northern Ireland and the Republic could never agree on what it should be; both sides are tribally opposed to the preference of the other. In effect the spat between the two is a microcosm of the UK/EU row itself. What relationship do they really want to have with each other? Both the UK and the EU have effectively been sending their second into the fight. The EU empowered Ireland by giving them the EU’s veto; the UK government is beholden to the DUP because of the minority government and the maintenance of the United Kingdom (note Scotland et al have already called for their own version of ‘regulatory alignment’).

Unfortunately, it could turn into a fight to the death.

A hard border would see customs officers employed in some shape or form, with long lines of trucks and cars on the only land border between the UK and the EU. To avoid it, the UK would have to remain in the Single Market and the Customs Union. Theresa May vetoed this when she took over as PM, in order to win over her Brexiteer colleagues and the 52%.

How to square this circle?

  1. An almighty tweak to the language that can allow both NI and the RoI to convince their electorates that they didn’t surrender to the other
  2. A fudge which allows the can to be kicked down the road
  3. The DUP accept a hard border
  4. The DUP stand strong
    1. and either the UK Govt capitulates to a Customs Union
    2. or the UK Govt calls their bluff, agrees to a soft border and dares the DUP to vote them down, knowing the DUP would lose £1bn from their post-election confidence-and-supply agreement, not to mention damage to the economy of Northern Ireland – as well as the damage to the United Kingdom as this opens the door for Scotland etc to have their own regulatory regimes

The most likely of these is that the DUP accept a hard border. The Union must be preserved at all costs. That’s their number one goal. Although Theresa wants progress at the EU Council talks, she, and her Cabinet, would prioritise the continuation of their government at all costs. Even if that means accepting a compromise like a hybrid Customs Union.

Could Ireland derail Brexit?

When a market can’t judge, it can’t price.

This means the latest news about Ireland and its border with the UK is being shrugged off. Even though it could entirely up-end the “sufficient progress” the EU requires for negotiations to continue.

But never fear! BlondeMoney is here to explain all, in collaboration with our correspondent from across the Irish sea. Here’s the Q&A with our man BallyMoney:

What border is currently in place between the UK and the Republic of Ireland? 

The Government of Ireland Act 1920 began the process of separating Ireland; the Irish War of Independence that followed led to the establishment of the Irish Free State on 6th December 1922. A day later, the Parliament of Northern Ireland (NI) opted out, effectively making what became known as the Republic of Ireland (ROI) an independent country. Customs controls between NI and RoI were then introduced on 1st April 1923 and continued until 1st January 1993 when customs checks were abolished under the Single Market of the EU. It was never necessary for Irish or British citizens to produce a passport when crossing the border but during The Troubles, as British military checkpoints regularly checked identification. This was phased out between 1998, after the Good Friday Agreement, and 2005. Both Northern Ireland and the ROI share a Common Travel Area, which has allowed the free travel of people since 1923 and goods since 1993. The border did however provide a physical barrier for police in ‘hot pursuit‘ of criminals/terrorists, a topic which has aroused much debate. Those born in Northern Ireland can apply for an EU passport as they are considered to be Irish citizens; as can their children, or their children’s children.

What happens to the border when the UK leaves the EU?

The border between the Republic of Ireland and Northern Ireland becomes an external EU border. The UK would have left the Single Market and the Customs Union, all of which would mean customs checks between ROI and NI. Or at least, that might happen. The trouble is that it’s not entirely clear what the UK exactly wants, given that there’s no consensus within the Cabinet, let alone the country, over what the UK outside of the EU looks like. Options include:

  1. In the Single Market but out of the EU is Norway: paying money into the EU without any say over its direction.
  2. In the Customs Union but out of the EU is Turkey: tariff-free trade but the EU negotiates your trade deals for you.
  3. In EFTA but out of the EU: The European Free Trade Association countries are all in the Single Market anyway, aside from Switzerland.
  4. Out of it all: negotiate bespoke free-trade agreements with all trading partners, but takes time to do it.

1 and 2 are considered politically impossible, given the Leave vote ran on the slogan to ‘Take Back Control‘.
That leaves 3 and 4, which would ensure a hard border for NI/ROI.

What’s wrong with a hard border?

As Jim Allister, a former member of the Democratic Unionist Party and a Member of the European Parliament at the time of changes to immigration rules in 2008 said it would be “intolerable and preposterous if citizens of the UK had to present a passport to enter another part of the UK”. This is a stance echoed by all unionists. However no party in Northern Ireland wants the return of a “hard border” as there’s so much trade that happens across it and everyone has been used to no controls. Equally the sight of gun-toting police at border checkpoints would arouse memories of a more difficult time in NI/ROI’s past.

The current debate, however, reignites a painful existential question for NI. Some argue it would now be better on economic grounds for Northern Ireland to unite with the Republic of Ireland or at least become closer to them and further from the UK. This is creating a headache for the government of the devolved Northern Irish assembly, which is already in disarray as the Nationalist and Unionist parties cannot agree on a power-sharing deal. NI has now been without a government since the elections on 2nd March. Although it was the first election since the 1921 partition in which the Unionists failed to win a majority, they regained some of the balance of power after the Democratic Unionist Party agreed to prop up the Conservative Party minority government following the UK’s General Election in June.

Why is this becoming an issue now? 

The new Prime Minister of the Republic of Ireland, Leo Varadkar lit the issue on 17th November with his scathing remarks that:

‘Britain, having unilaterally taken the customs union and single market off the table, before we move to phase two talks on trade we want taken off the table any suggestion that there will be a physical border, a hard border, new barriers to trade on the island of Ireland… Sometimes it doesn’t seem like they have thought all this through.’

He is a man seizing the opportunity.

Right now, the UK needs to make enough progress with the EU to be able to move onto trade talks in order to please the Leave voters. Also right now, the beleaguered UK Prime Minister needs the support of the DUP to prop up her government, and the Unionists need to ensure NI remains part of the UK. So Ireland can threaten to scupper the UK’s talks while driving home their own agenda to soften the border. If NI wants to remain part of the UK, and the UK wants to Leave the EU, then how does that square with both NI and ROI wanting a soft border?

How likely is this Irish row to derail Brexit? 

Very, it is the single biggest thorn in the side of Brexit and encapsulates the issues, i.e. the potential introduction of a proper border where virtually nothing existed for years; the free movement of people; the tariff-free movement of goods. What does Britain actually want?

It also encapsulates the issue that the politicians on all sides of the negotiating table are prepared not to ‘let a good crisis go to waste’, as Obama’s Chief of Staff once said. This means advancing their own agenda and wounding their opposition, rather than straightforwardly acting in the rational interest of their country.

Financial markets are currently rising above the messy issue of politics. At some stage the risk of a miscalculation will be brought home to roost.

Not all Tapers are Created Equal

Much head scratching and teeth gnashing after the Euro staged a significant rally out of thin air yesterday. Sure, it was kicked off by stellar German GDP and confidence data but that was offset by lower Spanish core inflation, but the bid in the Euro lasted persistently throughout the European day. Every single hour saw the price rally, and it’s the same story today since London opened at 7am:

Interesting that it only saw respite in the Asian trading session where it paused in those choppy red and green bars overnight. For those trying to construct this into some kind of greater theme of “risk off across all assets”, that doesn’t chime too well with the Nikkei down 1.5% as EUR/USD treads water. No, this kind of price action suggests an ongoing and persistent flow.

For consideration of the culprit, let’s take a step back from whether it was Professor Sovereign Plum with the Lead Euro Piping in the Library. It doesn’t really matter exactly who or where. The why is what counts, and for this we need to look again at that lovely speech that the ECB’s Coeure gave in July. He proffered some fab charts that proved just how turbocharged the ECB’s QE really was. Just look again at how large the net outflows from the Eurozone became once they announced their asset purchase programme:

This gave them a double whammy: domestic investors went into foreign debt, and foreign investors went into Eurozone equities. The upshot of that is that it led to a significant depreciation in the Euro. As Coeure flagged, these flow effects were huge. Records were being broken all over the place: “At their peak around the middle of 2016, net capital outflows – measured here in terms of 12-month moving sums – reached nearly 5% of euro area GDP. Never before in the history of the euro area have capital flows been so high‘ …. ‘By the end of 2014, shortly before we announced purchases of government bonds, annual inflows into euro area stock markets by non-residents had reached 4% of euro area GDP – the highest on record’.

But now the big QE programme is going into reverse. The greatest Jedi master of all managed to sell it so well that on the day he announced the ECB would be making fewer asset purchases each month, the currency and interest rates both fell. Mario Draghi can indeed give himself a congratulatory pat on the back – and may well be doing so right now at the ECB Communications Conference. He can even sit back with a smile and say, if the currency is rallying now, at least it started from closer to 1.1500 than 1.2000. In fact as of right now, we have got back to where we were in the Euro before that fateful October ECB meeting. Go on son! Another round of high fives for the M-Dawg!

One of the curious aspects of the ECB’s communications is how they have managed to wrongfoot stabilise the markets in this way ahead of their big announcements. They announced QE in January 2015, the Euro fell a bit, but only really started depreciating once they were actually in the market in March of that year. It follows that we are now starting to see the portfolio effects of their taper, even though they announced it on October 26th.

Futhermore, the level of yields matters. Blondemoney flagged in July how the negative yield euphoria couldn’t carry on forever:

But as that 2 year yield edged towards -1%, maybe something clicked. Maybe the ECB accidentally revealed the Emperor’s New Clothes when they announced in December that they would allow QE buying to take place at prices through the deposit floor level of -0.40%. This was really a technical change that meant they could continue to buy German bonds…It set off a rational drive down in the German bond yields, because extra demand came into the market. But maybe around -1% all the demand ran out. Fast forward a few months and now the ECB are openly rumoured to be discussing a taper of their programme, even as they’re not explicitly discussing it at meetings. If the mere discussion of a discussion can arrest the bond rally, then what happens when they actually discuss it and then actually do it?

The ECB’s Coeure is evidently a reader as in his speech he concluded:

‘In addition to yield differentials, the absolute yield level may also matter for investors, particularly if rates are negative. It may be no coincidence that net bond outflows were among the largest when ten-year German Bund yields hit a low of nearly -20 basis points last summer. In a recent survey among foreign central banks, 70% of the respondents reported that negative interest rates in the euro area had encouraged them to adjust their allocations to the euro.’

So wouldn’t it follow that a reversal of policy from the central bank might also encourage an adjustment to their Euro allocations?

This is significant, and not just for FX geeks. If rebalances are taking place, this means investors are now factoring in the long-awaited reversal in the decade-long monetary expansion experiment. It has been feared for so long, but without anything bad happening, that we would be forgiven for missing it. The taper tantrum was four years ago. The fear was over the Fed hiking rates. But it turns out the ECB were just passed the baton. Global central bank balance sheets have gone on increasing.

But no more. Why else did Coeure make that speech in the summer? The second half of it explains what a great favour they did to the world with their turbocharged global QE. He was preparing us for when the methadone would be withdrawn, telling us what a lovely time we had on it, but if we go painfully cold turkey now then it’s not their fault, right?

So keep an eye on the rally in the Euro. It’s not “risk-off”, it’s “liquidity-taps off“. Hence high yield and equities starting to get hit at the same time. Bonds will not be immune. If we are about to undergo The Great Repricing then curves cannot stay this flat. And that’s before we add in a political risk premium to US Treasuries…

The market is still in its slumber. Even after the 150 pt move in EUR/USD yesterday, the option market is only pricing a breakeven of 55 pts over tonight – even in a period including the US CPI release.

There have been many false dawns in calling for a return to volatility over the past few months. But now the stage really is set, with bears having all but given up, and risks increasing. The monetary taps are being turned off; political risks are rising (Zimbabwe joining the action today with a potential coup). Just as we enter the most illiquid time of the year (Thanksgiving next week). This is likely not yet The Big One, but it should be a significant tremor.

 

Elections a-go-go

At the start of the year, the European elections were the big event risk ahead. Fast forward nine months and this weekend’s German election is met with barely a shrug, thanks to the victory of an oedipal ingenue into the Elysee Palace. The threat of Marine Le Pen has receded so much that one of her closest aides has just quit the National Front, and with it, one of the key architects of their Frexit policy. The Eurosceptic knaves have been vanquished. Even a country that has voted to leave, will today see its Prime Minister lay out a policy for its exit that means it won’t exit for 2 years after it’s technically exited. Geddit?

Blondemoney forgives you for EU-fatigue. At some stage, the Brexit shambles negotiations will produce an almighty bout of excitement, but for now it’s just so earth-shatteringly nuanced as to be eminently forgettable. Hand us an instant-result FOMC meeting any day.

At least politics this weekend should provide a binary outcome.

First up it’s the German election. Although no-one really much seems to care about that, with Merkel consistently riding high in the polls, rarely troubled by the opposition’s Martin Schulz. The bookies have her party emerging as the largest at an eye-wateringly certain 1/100. Even as the largest party she likely has to enter a coalition, however, with the following potential scenarios that could emerge:

Given the market is totes not both’d, we might not get much of a reaction to any of those scenarios, but things to watch out for would be:

  • FDP joining a coalition – as they are the most “anti-Euro” of the larger parties
  • AfD gaining any kind of representation – or indeed, if they don’t, despite polling almost twice what they were in the last election, thus suggesting the anti-establishment vote is dying off

Next up it’s the New Zealand election. This had looked to be hanging in the balance with polls showing the charismatic new young (female) leader of the Labour Party driving them into the lead in the polls ahead of the incumbent National party. “Jacindamania” is now ebbing away, however, with the most recent polls giving National a clear lead of 7-10 pts. Again the market doesn’t seem too worried, probably because the New Zealand Dollar is most often used as just a proxy “risk on / yield hunting” currency. But there are potential pitfalls ahead. The Labour Party want to change how the RBNZ works, and introduce a Fed-style dual mandate; while coalition partners could include the anti-immigration party the NZF. Admittedly, the NZF have already been in government, and a new mandate for the RBNZ might not change much in practice.

Either way, we will have a sense of the result by 8am BST Saturday morning when the exit polls come out…
And for Germany, by 6pm BST Sunday evening.

(Although for both, coalition forming could mean the final government isn’t in place for a few weeks yet).

You might wonder why everyone is so relaxed, given how unreliable polls have become recently. Blondemoney would argue that polling accuracy is proportional to the proportionality of the voting system. In other words, if it’s a proportional representation system, then it’s easier for the polls to capture. The more it’s “first past the post”, or an electoral college, then it’s much harder to predict.

Both the German and NZ elections use a fairly proportional system – a mixture of PR and FPTP. For the election geeks amongst you, both countries actually use the relatively unusual ‘Webster/Sainte-Lague‘ method for determining seats from vote share. (And if that’s not your weekend reading sorted, I don’t know what is). So the polls should be decent at predicting the result. (Famous last words??)

Either way, from this point on, Merkel in charge of Germany means she can get on with taking the EU forward. That may be marginally Euro positive. For New Zealand, its currency can get on with being the favourite of those who like to trade EM without being able to invest in EM!