BNY Mellon: The Fed Put and the UK

1 feb 2019

By Simon Derrick, Chief Currency Strategist, BNY Mellon

• While UK PM has a mandate to negotiate with EU, what Brussels may ask in return could prove too much
• Uncertain path for the prime minister once the next meaningful vote takes place
• Little in the price action to suggest markets are factoring in potential risks

There is evidence to suggest that the Fed "put" has been a dampener of realized volatility in the FX markets. It’s therefore worth noting that since mid-January, 21-day realized volatility in the USD Index has been trending lower. Nowhere has this been more apparent than in the muted FX response to the events in the UK.

On January 15 the House of Commons rejected the negotiated deal for the withdrawal of the UK from the EU. This was the most decisive rejection of a piece of legislation ever by the UK Parliament.

In contrast, Tuesday evening saw Prime Minister Theresa May gain a mandate from Parliament (317 votes to 301) to reopen negotiations with the EU. The specific amendment she was mandated to seek from Brussels was that the Northern Ireland backstop be replaced with “alternative arrangements” to avoid a hard border.

Hints at what it might take to come to an agreement have emerged.

A report over the weekend said that that European Commission President Jean-Claude Juncker had told the UK PM that shifting her red lines in favor of a permanent customs union was the price she would need to pay for the EU revising the Irish backstop.

Similarly, MEP Danuta Hubner said yesterday that the EU could offer the UK more assurances over the Irish border if London moves towards accepting a permanent customs union. She added: "If there is no openness on the UK side to include those assurances in the political declaration on the future EU-UK ties, the process could mechanically take us to no-deal".

It’s uncertain whether the UK PM would be prepared to do this. While she might count on Labour Party support, it would likely create unrest within her own party.

There is consequently a risk that Mrs May will be unable to reach an agreement with the EU that deals with the backstop to the satisfaction of a sufficient number of MPs to get it through Parliament by February 14.

What happens in two weeks therefore remains open to question. It’s possible that the same deal as now could be put in front of Parliament (technically this is not supposed to happen).

However, it’s also possible that this vote would leave the house deadlocked again. With the EU’s scant appetite for extending Article 50 beyond the end of June, the PM would have to consider carefully what options she would have to break this deadlock.

It would be hard to guess these issues were there, however, if the only clues available were market pricing.

GBP continues to trade close to its post-referendum averages against the EUR and USD, while three-month at-the-money forward implied volatility in both pairs has sunk steadily since mid-December, despite events in Parliament and no simple path to anything other than a no-deal Brexit apparent at present.

This suggests a market that could find itself easily blindsided.