It is Brexit crunch time next week as the House of Commons may face three votes in just three days. Although the mood has clearly changed in a positive direction in the last couple of weeks, there is still a risk of adverse scenarios unfolding. Consequently, we see downside risk for the GBP short-term. Longer out on the horizon, however, we still expect a deal to be reach which should pave the way for a stronger sterling.
The three contingent votes that prime minister Theresa May recently pledged to hold will proceed as follows:
i) March 12: Meaningful vote on May’s Brexit deal
ii) March 13: If vote i) fails, the Commons will vote on a no-deal departure
iii) March 14: If vote ii) fails, the Commons will vote on an extension of the March-29 deadline for a “short, limited period”.
Graph 1: Brexit timeline
Optimism spurred by Brexiteers’ softening stance…
There have been several drivers fueling Brexit optimism. Most of them, however, point in the same direction: Hard-line Brexiteers such as the European Research Group have softened their stance towards May’s Brexit deal.
Thus, while the ERG earlier demanded that the controversial Irish backstop was scrapped altogether for “alternative arrangements”, the ERG could now accept an appendix that includes i) a legally binding clause that “unambiguously overrides” the text of the withdrawal agreement, ii) an “exit route”, and iii) stronger language about the Irish backstop only being temporary.
Ironically, the ERG’s more conciliatory rhetoric has to a large extent been triggered by Labour, as leader Jeremy Corbyn has officially given his support to a second referendum (although still keeping a range of options on the table). This has clearly scared some Brexiteers. Furthermore, it has paved the way for May to present herself as the only leader committed to defending Brexit.
On top of this, May’s pledge to have a contingent vote on an extension of the March-29 deadline, and the following overwhelming support in the House of Commons (Cooper-amendment: 502 MPs voting “for” and 20 “against”), sent a statement to the ERG that a no-deal is unlikely. Some Brexiteers therefore feel the pressure of facing a binary choice between May’s deal and no-Brexit.
…but a deal is still against the odds
Given the optimism, we judge that May’s deal (the “Meaningful Vote”) has a decent chance of passing on March 12 with a likelihood of around 25%. Our base scenario, however, remains that the deal will not pass (yet). Our scepticism is based on three arguments:
1.This week has not brought any signals that Attorney General Geoffrey Cox and Brexit Secretary Steve Barclay have been able to get any concessions from the EU on the Irish Backstop. This seems to be a deal-breaker for both the majority of the ERG and the DUP
2.The incentive of the Brexiteers to accept a deal next week is less with a “short and limited” prolongation compared to a long extension (>9 months), as the latter would increase the “risk” of a no-Brexit and also keeps the UK in the EU for even longer, while a “short and limited” prolongation keeps no-deal on the table
3.Labour MPs are necessary to pass the deal, but most sources indicate that possible rebels are not ready to risk their own career internally in the party, unless they see a clear chance of the deal passing through
Overall, we expect May’s deal to be rejected by a majority of around 40-70 MPs. This would be much less than the historic loss in January when a majority of 230 voted against the deal. We expect the DUP to vote against the deal again while around 20 Labour MPs, on the other hand, will vote with the Government in line with indicative votes held since January 15.
Noteworthy is also that the MPs can table amendments – one of which will likely be from Labour which seeks a public vote. We, however, expect this as well other amendments to be shot down with a comfortable margin.
If May’s deal is rejected as expected, we are confident that the Parliament will shoot down the prospect of a no-deal on March 13 and instead accept an extension of the deadline on March 14. The reason for this is that the House of Commons has demonstrated that it wants to avoid a no-deal outcome.
New Brexit deadline before July
The EU27 has to unanimously accept an extension of the March-29 deadline, which we believe it will. We thereafter expect the new Brexit deadline to be in mid-June. This is based both on May’s assertion that an extension would be “short and limited” and the requirement of new British MEPs to assemble in the European Parliament by July 2 at latest, in case the UK is still a EU member (EP election coming up May 23-26, see timeline).
Ultimately, we still expect a deal to be reached. A no-deal is not in the interest of the vast majority of the UK Parliament nor the EU, while a second referendum faces a lot of obstacles with the biggest one being May’s opinion that it would be a “democratic betrayal” (see more arguments here). But at some point, something clearly has to give. We think it will be ideology, so pragmatism can win.
We consider next week’s series of events a classic “buy the rumour, sell the fact” case. Thus, a rejection of Theresa May’s deal and an extension of the deadline are probably already priced in. Short-term risk reversals are at relatively low levels trading some distance away from the November spike, while betting markets are pencilling in around 15-20% of May’s deal passing. Finally, analysts are also expecting a delay, although with more optimism than markets.
If our base case unfolds (majority of 40-70 MPs rejects deal + extension), we expect EUR/GBP to head 0.5-1% higher in the coming weeks. In case of a deal being accepted, we judge that both the GBP and the FTSE 100 would rally 3-4%, while the yield curve would steepen and shift upwards around 15 bp.
Growth and BoE reaction
The Brexit uncertainty has clearly put a lid on UK growth – especially via declining business investments and new orders. Hence, recent PMI figures suggest Q1 GDP around 0.0-0.1% q/q (Q4 2018: 0.2%). Although an extension of the deadline should limit the fear of a no-deal a bit, we expect growth to remain sluggish in Q2 as uncertainty prevails. Furthermore, the euro area is currently facing a growth slowdown.
Once there is clarity about Brexit, we expect an immediate jump in growth in Q3. Growth should also be supported by a looser fiscal policy (as announced in the recent budget) by roughly 0.3% of GDP. This will, however, probably not be enough to prevent GDP from staying below potential at around 1.0% y/y for 2019.
In terms of monetary policy, the Bank of England is currently on “Brexit hold”. The MPC members are, however, wage hawks and would be in hiking mode if not for Brexit, as was also indicated by Mark Carney this week. We have currently pencilled in a rate hike in August on the assumption that a deal is reached in mid-June, but the risk is clearly tilted towards a move later (then likely at the November meeting). Thus, the Bank of England has a reputation of not taking any rush decisions when dealing with Brexit uncertainty and would therefore likely want to get a clear confirmation that growth is bouncing back after a potential deal is reached.
* You can read a fuller version of this article on emarkets here
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