Sterling rallied on Thursday after UK Prime Minister Boris Johnson and Irish Taoiseach Leo Varadkar agreed they “could see a pathway to a possible deal.” The Irish Times suggested that there had been “significant movement” from the UK on the customs issue. The pound appreciated by 1.9% against the dollar – its second largest daily gain in two-and-a-half years – and 1.6% against the euro on 10 October.
At the time of writing on Friday morning, sterling had extended its gains by around 0.5% as EU chief Brexit negotiator Michel Barnier and UK Brexit Secretary Stephen Barclay met for talks in Brussels. European Council President Donald Tusk hailed the “promising signals.”
In contrast to earlier in the week when European Union officials were highlighting the shortcomings of the UK government’s suggested compromise on Northern Ireland, the Johnson-Varadkar meeting suggests a greater willingness from both sides to look for common ground.
That said, reaching a deal by 19 October remains extremely challenging. Even if Johnson can find areas of agreement with the EU, any new proposal would still have to be approved by Parliament, where the government relies on the backing of Northern Ireland’s Democratic Unionist Party, whose support can’t be guaranteed.
In the absence of a deal by 19 October, the UK government is required by law to ask for an extension rather than leave the EU without a deal. As things stand, we still think that the most likely outcome is an extension, followed by a general election.
As yet there has been no concrete progress, sterling’s large move is consistent with our opinion that the currency markets have been pricing too high a risk of a no-deal Brexit on 31 October. In our FX strategy we are overweight the British pound versus the US dollar.
In our view, a convincing deal could result in GBPUSD rallying to 1.35 and EURGBP dropping into the low 0.80s. Sterling should also gain in the more likely scenario of an extension followed by a call for a UK general election in November or December. In that case, we would expect GBPUSD to settle between 1.25 and 1.29 and EURGBP between 0.85 and 0.88. The key risk after a Brexit deadline extension would be that an election could deliver a Parliament in favor of leaving without a deal at the end of the next deadline. We continue to think that a no-deal Brexit could see GBPUSD around 1.12 and EURGBP around 0.97.
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