How Markets May React to a Brexit Deal

How Markets May React to a Brexit Deal

After a difficult few weeks, the news on Brexit has moved quickly; an agreement has now been reached on the draft text of the separation agreement. A likely Brexit deal has near-term and longer-term implications for markets: We expect volatility as the process moves forward, along with a potential rise in UK sovereign yields and strengthening of the pound, though some Brexit-related risk premium is likely to remain.

The draft Brexit agreement addresses an interim solution to the Irish border if the final trade deal is not settled by December 2020. The solution of a UK/EU customs arrangement resolves the issue of how to prevent a so-called hard border being created between Northern Ireland and the Republic of Ireland. However, it also raises new issues of whether the UK has any control over the regulatory standards within that customs arrangement, and how the UK might eventually leave it.

Already there has been commentary from a variety of MPs on this very issue, and therein lies the challenge for Theresa May’s government: how to tread the difficult path of placating the various constituents of the Conservative Party and their partners in Northern Ireland’s Democratic Unionist Party (DUP), many of whom have differing views of the Brexit they want to see.

Now that the first hurdle of the UK Cabinet meeting is completed, the focus moves on to the degree of backlash from Conservative and DUP MPs, as well as the reception the deal receives across Europe. There will no doubt be many more headlines, and lots of uncertainty remains. However, we believe that both sides ultimately want to come to an agreement, albeit for different reasons.

Transitional agreement remains the likely outcome

Within the Conservative Party, while deep divisions remain, the transition deal leaves plenty of room for future negotiations, which should provide all sides with enough reason to ultimately support it. Similarly, from the EU perspective, the UK would remain closely aligned with the EU until at least December 2020, and therefore is likely to fulfill its obligations to the EU budget over that period. So while there remains a game of political brinkmanship, it remains our expectation that the transition deal will ultimately be signed.

This however doesn’t mean the next few weeks will be without volatility. In particular, market participants will be focused on the reaction to the deal in Europe, while also trying to understand the likelihood of it getting through the UK Parliament in December. There is also the risk of something going wrong at the EU/UK summit, expected to occur in late November.

Investment implications

In the event there is a transitional deal, and it passes the various political hurdles, we would expect UK yields to rise, and gilts to underperform global bonds, as short-term uncertainty is reduced. With the UK economy at full capacity and some signs of wages rising, a deal also increases the likelihood of the Bank of England raising interest rates more than is currently priced in by markets (two rises over the next two years). This would in turn support the British pound. We would also expect yields on UK bank debt to unwind some of their premium relative to global peers. In each case, not all of the Brexit risk premium is likely to unwind, but each step towards a stable future trading arrangement certainly helps.

Mike Amey is PIMCO’s head of sterling portfolio management and ESG strategies. He is a regular contributor to the PIMCO Blog.

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