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Brexit negotiations hit stumbling block

Today's news headlines:

  • ‘Brexit talks reach stand-off as May brands draft deal a “non-starter”’. The prospect of complete breakdown increases after a tense meeting between UK Brexit secretary Dominic Raab and EU chief negotiator Michel Barnier. (The Financial Times)
  • ‘Bavaria election humbles Merkel allies, raising tensions in Berlin’. German Chancellor Angela Merkel’s Bavarian allies suffered their worst election result since 1950 on Sunday, bleeding votes to the far-right and the ecologist Greens. (Reuters)
  • ‘Saudi Arabi and US clash over Khashoggi case’. The disappearance of the Saudi dissident Jamal Khashoggi is opening a rift between Washington and Saudi Arabia as the kingdom blasted President Donald Trump for promising ‘severe punishment’ if the royal court was responsible. (New York Times)
  • ‘Draghi to Rome: Don’t expect an ECB rescue if budget talks fail’. ECB President Mario Draghi said he was confident that a budget agreement would be reached and urged all parties to ‘calm down with the tone’. (CNBC)
  • ‘Labour MPs reveal they are ready to rescue Theresa May’s Brexit deal in Commons vote’. Boost for the Prime Minister as she faces having to rely on opposition votes to secure parliament’s support and deliver EU withdrawal. (The Independent)

Friday’s trading was dominated by consolidation. News on US bank earnings helped to justify lofty equity valuations, at least in the short-term. The US S&P 500 managed to stage a partial recovery, trading 1.3% higher on Thursday’s close. The Dow Jones also received a boost, its first day higher in four sessions. However, both indices were well off their pinnacles for the week. The positive correlation between stock and equity markets finally broke on Friday, with 10-year US Treasuries lower and the corresponding yield higher.

The equity market moves on Friday set the tone for currencies. The US Dollar trade-weighted index managed to rally 0.25%. Six of the 10 G10 currencies traded lower against the Greenback, with the Pound the clear loser. Traders took off Sterling long bets despite rumours of an imminent UK-EU agreement as soon as Monday. Traders wanted to protect their positions from weekend Brexit headline risk, and as trade opened this Monday, their fears were proved right.

We suggested previously that the closer Prime Minister Theresa May got to clinching a deal with the EU, the further away the prospect of the current deal passing UK Parliament became. The EU construct means that country leaders must always balance national politics while answering to a supra-national power. The current ‘temporary customs arrangement’ proposal for the Northern Ireland backstop is undermining May’s government support on two fronts. First, the lack of an expiry date on the temporary customs arrangement has Eurosceptic Conservative riled that it could mean the UK stays in the EU customs union indefinitely. On the second front, Northern Ireland is in a separate regulatory territory to the rest of the UK and needs checks in the Irish Sea, which has the Democratic Unionist Party threatening to bring down May’s government. Our back of the envelope calculations had the current EU-UK Withdrawal Agreement receiving the support of 235 MPs in the House of Commons versus 415 against. The current EU-UK agreement means the deal not passing the ‘meaning vote’ in parliament is a real possibility.

Developments over the weekend showed May’s allegiance was to domestic politics or perhaps this was the narrative she is trying to create. May despatched her Brexit secretary, Dominic Raab, to Brussels on Sunday to make clear that the current draft treaty was a ‘non-starter’ and that she could not sign up to the current terms at the EU Council meeting this Wednesday. Raab’s meeting with EU chief negotiator Michel Barnier lasted only an hour, showing that the news was not warmly received. No further talks are scheduled.

It’s hard to tell exactly whose bluff Mrs May is trying to call - the EU’s to force them to impose an expiry date on the temporary customs arrangement and/or allow the whole of the UK to remain in the EU regulatory area, or the UK Parliament’s. The threat of a no-deal Brexit could put all their tough rhetoric to the test. News headlines this morning show the latter may already be working.

The EU Council meeting this Wednesday will now be key for Sterling and a Brexit deal. The critical thing to watch for is the announcement of a special EU Council Brexit summit in November. Earlier comments from EU Council President Donald Tusk stated that a special November summit would only take place if ‘maximum’ progress had been made at the 17-18th October meeting. An announcement of a November summit would be Sterling positive.

We continue to believe a soft orderly Brexit will be reached by March 2019 on either UK domestic politicians or the EU yielding. The recent deterioration in German exports and manufacturing output will increase pressure on the EU to reach a deal. However, recent developments mean tail risks have increased in probability, particularly an extension of Article 50. This buying time exercise would require a unanimous agreement by the EU27. This would be tricky, but in a knife-edge situation, we believe it could be done.

For the day ahead, markets will be looking for a rebound in the US October Empire Manufacturing survey after it dipped to its lowest level in four months in September. US September Retail Sales will be the main release of the afternoon and is a health check on US consumers’ spending habits, which account for about 70.0% of US Gross Domestic Product (GDP). The retail sales figure is not price adjusted; therefore, a sharp decline (3.0% MoM) in used auto vehicles prices during the month, along with delayed spending due to Hurricane Florence could depress the headline figure. US August Business Inventories and Canadian September Existing Home Sales and Bank of Canada (BoC) Q3 business and credit outlook surveys will also be published. New Zealand’s Q3 inflation data will be released overnight.

Monday is the deadline for Italy to submit its draft budget plans to the European Commission. The country has already announced a deficit of 2.4% of GDP for 2019, putting them in breach of EU rules. The government has stood by its plans, withstanding a sell-off in its sovereign bond market and escalating borrowing costs. Now it must withstand the EC who could start an excessive deficit procedure against the nation.