Why I'm Not Buying The Rally In Sterling

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Includes: FXB
by: Max Greve
Summary

Sterling has risen sharply the past few days as Parliament has continued to vote on Brexit.

The recent Parliament vote against no-deal was non-binding, and doesn't amend the law which requires Britain to leave on March 29.

The vote tomorrow is a non-binding vote only, for an extension that is temporary only, and which the EU may not even agree to.

Sterling's rally after the vote is premature under these conditions.

For those who maybe aren’t following the situation that closely, Britain’s Parliament voted on Brexit recently (yes, again) and passed a motion declaring that Britain should not leave the EU without a withdrawal agreement (“a deal”) in place. Sterling (NYSEARCA:FXB) has shot up on the news and the general reaction has been that the decision is both very bad for Theresa May’s prospects - very true - and very good for the prospects of economic stability in both Britain and, to a lesser extent, the EU as well, though the EU was never seen as being nearly at risk as Britain.

This second conclusion I have a little more trouble with. In the first place, no-deal has not been taken off the table, despite the press reaction. In the second place, it isn’t even entirely clear that Parliament can take no-deal off the table without calling off Brexit entirely, and even the Leader of the Opposition isn’t even sure he wants to call Brexit off entirely.

I remain convinced Brexit is probably going to happen, and since I don’t think it will go particularly well, I remain bearish on sterling.

Sterling's Recent History

Since I’ve been writing about this topic for a little while now, and am presuming to write about it again, I should tell you how my last Brexit prediction went.

When sterling was trading at $1.30, and another Contributor suggested going long sterling and short British equities because Brexit would not happen at all, I took the opposite view and said sterling would not rise and might even fall because Brexit was not actually being stopped. Sterling rose to $1.32 before falling to $1.28 and then settling back at $1.30. Then it shot up to $1.33, and then it went back to $1.30 again heading into this week.

So, heading into the most recent round of votes, we’ve more or less hung in place. I consider that at least a modest vindication of my view that sterling would “continue to price in Brexit,” as I put it at the time. But only a modest one. At the height of Brexit expectations sterling traded for $1.20, so clearly there is some “no-Brexit” sentiment left in the currency.

This week, meanwhile, has seen sterling shoot back up to $1.33 again. So the question is the same as last time. Is this boost going to last?

Understanding What Has (Hasn't) Happened

Sterling has done this largely because the general reaction to the Prime Minister’s defeats of the past few days - her own deal was voted down by 149 votes, the day before no-deal was “taken off the table” by 43 votes - is that it so eviscerates the PM’s authority that no Brexit becomes not just possible, but the most likely outcome. The idea being that if the PM wants Brexit, and she is losing votes in Parliament, then it must be because Parliament doesn’t want Brexit.

Understandable take, but not really. Mostly, Parliament just doesn’t like the PM at this point, not even her own party. But that’s a political topic for a political article on another site. The economically relevant point is this, and it’s one I’ve made before: every time Parliament holds a vote like this, the vote is non-binding. It’s a “sense of the House” resolution that doesn’t actually change the law. Which is a problem for Remainers, since the original vote to trigger Article 50 and leave the EU in 2017 was binding, and is now a legal requirement.

Biding Time On Binding Vote

No problem, Parliament will just make it binding, right? Well, maybe, and certainly right after the vote last night several MPs immediately began asking the Speaker how soon they could bring a binding bill forward. But before taking this as a given, we need to remember something: this isn’t the first time this has happened.

Two months ago, Parliament passed another, not legally binding, “no no-deal” resolution. That one got 318 votes, only three less than the 321 that this motion got. So the net movement in this “crush Brexit” vote that was held was 3 MPs. More significantly, however, last time two other amendments voted on earlier that same day would have made legally binding changes to the withdrawal date - and Conservatives and the DUP united to vote them down, by more than 3 MPs. So that proposal may still not have the votes to pass.

So Parliament has been expressing its sentiments for a while now, but it never quite agrees to take the plunge of binding the government. And it’s not clear it will now. And the PM herself remains committed to Brexit. As for that matter does British law.

Currency Implications

Sterling therefore may come under renewed pressure, because even those committed to Brexit largely agree that at least in the short-term, there will be pain. Some have called for the currency to go below parity with the dollar, and while that is probably an extreme, experts put a fall to as low as $1.10 a real possibility.

It is also likely that inflation would surge and unemployment would rise, two other bearish factors for a currency. The Bank of England’s projections have called for a “misery index,” as Reagan used to call it, to go as high as 15%, split evenly between the two evils.

Extension Tension

Sterling might hope for at least a temporary boost from a Brexit extension. Each extension would make it progressively less likely that Brexit would ever get implemented - the first extension will probably be the hardest - and even Prime Minister May is now saying she might be willing to go back to the EU and ask for one. Thus, an extension might well cause a substantial boost in the value of the pound and obviate my bearish thesis for sterling. Sterling was trading at $1.50 before the EU referendum vote to leave. A failed Brexit could conceivably put it back close to that.

The problem here is, Britain can’t just decree an extension. It can only ask for an extension, at which point the EU27 have to unanimously agree to it. And that might be a tall order, even more so than most unanimity-bound decisions. The EU has already said it would only grant an extension if the extension were for the purpose of implementing a plan. That is, the extension would have to be paired with Parliament passing a decision about what to do about Brexit, whether that was Norway-Plus, Canada-Plus, a Labour alternative, or even the PM’s own deal, though no one but her seems to think that is going anywhere.

If Parliament were capable of doing that, it wouldn’t need an extension in the first place. And that raises the real risk that even if Parliament votes to request it in the near future - and, since this one’s non-binding too, even if May decides to follow the “advice” - the EU might simply say ... No.

Conclusion

Optimism about sterling still seems premature to me, much as it did two months ago. A sustained rise in sterling requires some degree of certainty about Brexit - certainty other than the no-deal scenario, which is still the law right now. Between the difficulty of getting an extension and Parliament’s inability to agree a plan - and its unwillingness to simply call the whole thing off - Brexit remains very much in the cards, and should remain priced into sterling.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.