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Update, Tuesday 10 July: Shortly after this week’s bulletin went out, the UK foreign secretary Boris Johnson also tendered his resignation – with the result that UK markets were briefly rather less sanguine than described below.
As of this morning, it appeared that the contagion – both political and financial – had been contained. There have been no further ministerial resignations, and sterling is currently trading at around $1.325, 0.75% below its level prior to Johnson’s resignation. The lingering uncertainty does not help the pound, but for now it seems that May has seen off a leadership challenge. Last night’s rumours of an imminent vote of confidence (which could be triggered by 48 conservative MPs writing to the chairman of the 1922 committee) have not reached fruition, with the prime minister instead addressing her backbenchers to the sound of thunderous applause.
Time will tell if May survives, but for now she appears to be in charge of a more malleable cabinet and heading for a softer Brexit. This path should reflect a stronger pound – hence the limited damage so far, as the market weighs up both the likelihood of this and the potential for a rate hike in August, which still hangs in the balance.
Well, it was fun while it lasted. For a whole six months, it’s been possible to talk about UK market risk by reference to fundamentals rather than the latest political headlines. Alas, no more: with the resignation last night by David Davis, the Brexit secretary, quaint considerations like GDP and inflation have once more been upstaged by the internecine squabbles within the Conservative Party.
No matter what angle you approach the debate from, it is difficult to see Davis’ resignation as good news. Coming as it did just 48 hours after Number 10’s attempt to restore “collective responsibility” for its soft Brexit negotiating position, it could hardly do more to underscore the prime minister’s inability to hold the whip hand over her government. Depending on how quickly and successfully Theresa May can reshuffle her cabinet, not to mention the question of whether there are more resignations of pro-Brexit ministers still to come, the prospect of a general election is back on the cards. Along with that, of course, is the very real possibility of a change in government and near-total restarting of the negotiation process – and all with less than three months to go before the final deal needs to be with the EU parliament if it is to be ratified by March 2019.
Just a couple of years ago, this level of uncertainty could reasonably have been expected to plunge the financial markets into turmoil. Look at the charts this morning, however, and you’d be hard pressed to work out that anything unusual had happened over the weekend. At the time of writing, the pound had not just held its level but edged up against both the dollar and the euro. Meanwhile, the five year GBP swap rate – which in recent years has occupied a dual role as both a measure of interest rate expectations and a barometer for the health of the UK economy – responded to the news by jumping four basis points, to 1.35%.
The explanation adopted by a number of banks’ currency strategists is that markets are sanguine with good reason. Davis’ resignation so soon after the prime minister seemed to have brokered an agreement within her cabinet to keep the UK in close alignment with the Single Market and Customs Union is undoubtedly a blow, but it is also not particularly surprising. The former Secretary of State’s desire to leave the EU with something approaching the hardest Brexit possible has been known for at least a couple of decades, and since November 2017 he has threatened to resign no fewer than five times in protest at the government’s negotiating position. Moreover, his replacement by Dominic Raab will see the government gain a chief negotiator who combines the necessary quality of being an ardent Leaver with the rather rarer one of being widely viewed as a pragmatist with whom both wings of the Conservative Party can do business. Add to that the fact that, unlike Davis, Raab has significant experience of negotiations other than internal party quarrels (he spent the late 1990s in Palestine working for one of the chief negotiators of the Oslo peace accords) and you could be forgiven for thinking that the UK’s position has actually improved.
This assessment is tempting, and its logic will certainly appeal to economic forecasters committed to models in which the participants act rationally. Unfortunately, as observers of UK politics over the past 30 years can attest, the application of such models to a Conservative Party that is peculiarly eager to tear itself apart over “the European question” is somewhat optimistic. Like the financial markets, as we saw through the 1980s and early 1990s, it is able to limp on in an apparently unstable position for longer than anyone would have predicted. When the dominos start to topple, though, it doesn’t take long for the whole edifice to fall down. Davis’ resignation could be a bump in the road for the Brexit process – or it could be the signal for his party to ditch the interests of both the country and themselves in favour of the bacchanalian pleasures of political infighting.
As for the market implications, it looks like we are set for another tense summer. The Bank of England has once again spent the last month preparing traders for a rate hike at its next ‘Super Thursday’ on 2 August, and the overnight interest rate swap markets are now pricing this in with a probability of 81%. It would be a brave Monetary Policy Committee that followed through on this in the face of further cabinet resignations, however, and in any case the decision by the Office for National Statistics to delay publication of the last three months’ GDP data until after the meeting has made this expectation seem rather overblown for some time. As for the currency markets, the direction of sterling will likewise depend on whether Davis’ former colleagues decide to follow him in abandoning ship. One thing we can say for certain though: now is not the time to sell volatility.
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