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Brexit – Major risk for the GBP

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Bank of America present a note about Brexit and its implications for the pound:

“The 18/19 February EU Summit on the renegotiation of UK’s terms of membership will be the major focus for GBP over the coming week. The draft deal announced by PM Cameron and Donald Tusk, President of the European Council on February 2nd was broadly in line with our expectations and has increased the chances of a June 23rd Referendum. But no referendum date will be announced until a final deal is agreed upon but the fact that a draft deal was published suggests the chances of agreement next week are high. The 23rd June date also fits into a timeline that requires a 16-week gap between announcing and holding a referendum.

Nonetheless, the draft deal is no guarantee that an agreement will be reached and according to news reports, Tusk continues to see the process as “fragile” despite positive noises from other EU officials in recent weeks. Since February 2nd, Cameron has conducted a tour of Europe to meet other EU leaders in an effort to convince them on the merits of the deal. The Visegrad Group (made up of Hungary, Poland, Czech and Slovenia) in particular is a key bloc within the EU and Cameron has already secured the support of Poland for a re-negotiated deal. The details of that agreement remain light.

Hard details yet to be finalized. It is important to note that whilst the February 2nd deal will form the basis of any agreement next week, hard details are yet to be finalized. Cameron aimed to renegotiate four aspects of the UK’s relationship with the EU: sovereignty, economic governance, competitiveness and access to welfare. The last issue has proved to be the most contentious. The UK wants the ability to ban EU migrants from accessing UK in-work benefits for four years after their move to the UK. That would have undermined the EU principle of non-discrimination by nationality. So it seemed unlikely that Cameron would get exactly what was requested. Accordingly, the draft did not seem to go all the way to Cameron’s requested changes. Nonetheless, PM Cameron said afterward that it was sufficient, if agreed, for him to recommend remaining in the EU.

Implications for GBP: As stated, the February 2nd draft deal makes an agreement next week more likely. However, given the public and press reaction already to its release, we think an agreement in its current form is likely to be neutral for GBP.
Given the latest comments from Tusk on the fragile nature of the deal, the scenario of no deal being reached at all would be negative for GBP and could send sterling meaningfully lower versus a broader set of current account surplus currencies (JPY, CHF, EUR) as well as USD.
No agreement effectively pushes the timing of the referendum into Q3 and with it a prolonged period of uncertainty and doubts about the sustainability of the UK current account. However, we think the scenarios that are the best case for GBP may not immediately be bullish for GBP as much will depend on the reaction of the press and the opinion polls more importantly.
Should Cameron achieve the promise of eventual Treaty change on in-work benefits and perhaps even a safe guard on the sovereignty of the UK Parliament, we think this would be bullish for GBP as it would go a long way in appeasing those in the Conservative Party (notably Johnson) who are wavering on which way to campaign at the Referendum, thus enhancing the chances of the “Remain” camp and ultimately supporting our view that Brexit risks are exaggerated.
However, the sustainability of the initial GBP rally will probably be contingent on whether the agreement leads to a turning point in the opinion polls, something that the draft agreement was not able to achieve. In addition, the extent to which an enhanced deal alleviates the Brexit risk premium as proxied by relative moves in UK CDS will inform us if the initial rally in GBP on this scenario is durable. “

DETAIL OF BRITISH & EC FLAGS

DETAIL OF BRITISH & EC FLAGS

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