UK markets experienced another week of high political drama, as the twists and turns of the Brexit negotiations continued to impact asset prices. Government bond yields and the British pound fell to lows for the year as the government withdrew the Brexit bill, which in turn prompted a challenge to Theresa May’s leadership. In the event, May prevailed in the leadership vote, but was forced to announce that she would make way before the 2022 General Election. While this certainly helped her win the vote, it leaves her authority challenged as she negotiates with the European Union (EU).
Thereafter the second half of the week proved no less dramatic. After guiding expectations towards further negotiations at the EU summit and beyond, a tense set of meetings deflated the optimism around a negotiated compromise.
So where does that leave the UK now?
Three potential outcomes
Whilst trying to chart the precise course of the Brexit negotiations is extremely challenging, there appear to be three broad outcomes:
- Withdrawal bill passes: There is still the chance that the UK and EU can successfully navigate the current impasse such that both the UK and EU Parliament pass the negotiated withdrawal bill and the process moves on to discuss the future trading arrangement. While we still see a material chance of this happening, it is perfectly possible that the current impasse remains, in which case two potential options arise.
- No deal: The first option is that the UK still leaves the EU on 29 March 2019, but with no deal and therefore moves to trading on World Trade Organisation rules. As there seems nothing close to a majority of British MPs who would accept this, we see this as a low probability event.
- Article 50 extension: Rather, we believe that MPs would either legislate to extend the Article 50 period (where the UK continues to temporarily remain in the EU) or revoke the Article 50 notice, pending greater clarity on the way forward. In each case the status quo would continue.
How will markets react?
We believe markets are now broadly priced for an extended period of the status quo – where the current impasse remains, but the UK remains in the EU. For example, the muted market response to Thursday’s difficult EU Council discussions would seem to support the view that markets are now priced for stalemate. Indeed, despite the daily volatility, UK bond yields are little changed from levels prevailing before last week’s events, and the British pound is just 0.5% weaker.
For those looking through the noise, with UK yields still low in a global context and the market priced for just one additional UK rate hike, any improvement in the Brexit negotiations would support rising UK yields relative to their global peer group, and potentially some modest recovery in the pound. No doubt uncertainty will remain high, but for those thinking longer term there are opportunities to profit.
Mike Amey is PIMCO’s head of sterling portfolio management and ESG strategies. He is a regular contributor to the PIMCO Blog.