Mays Italian job has she got a great idea

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By :  ,  Financial Analyst

When UK PM Theresa May takes to the stage in Florence on Friday to give her lauded Brexit speech, she had better deliver. Not only will the eyes of the world and the financial market be upon her, but this speech has held up the fourth round of Brexit negotiations by a week.

Divorce Bill expectations

The importance of this speech cannot be over-emphasized, not only is it expected to lay out the UK government’s long term strategy for Brexit, but it is also expected to give the Europeans what they have demanded before they are willing to move onto the next stage of the negotiations: the size of the Brexit divorce bill that the UK is willing to pay. Expectations on the size of this bill vary from £20bn -£50bn, with some expectation that part of this cost will cover our EU dues for a transition period of 3-5 years, which will assure access to the Customs Union and Single Market one we leave the EU in March 2019.

Hard vs. Soft

So, money and policy direction are the two big set-piece demands from this speech that Theresa May must deliver on. It also gives her the chance to calm her cabinet and wrestle back control of the debate from her pesky Foreign Secretary Boris Johnson, and from the hard-line Brexiteers’ that she undoubtedly has to please at next month’s Tory Party Conference. The hard vs. soft Brexit rhetoric from the PM this Friday will be important for FX traders, since the hard Brexit rhetoric has proved in the last year to be kryptonite for the pound. Thus, if May can swing the debate back to a soft split from the EU then it has the potential to further reduce the political premium on the pound and trigger another leg higher in the sterling rally.

May’s speech and the pound

As we lead up to the PM’s Florence speech, EUR/GBP is in consolidation mode and GBP/USD has hesitated at the $1.35 mark. This comes after last week’s largest weekly gain in GBP since 2009, and it also suggests that markets are waiting for May’s speech before they make their next sterling move. As we mention above, this speech will be a good indicator of whether the UK government has shifted its stance from a hard Brexit to a softer approach, which means that the outcome of the speech could be a binary one for the pound: a softer approach is pound positive, while a hard Brexit could send the pound tumbling once again.

Reducing the political premium 

The pound is still 10% lower vs. the USD since the EU referendum result last June, which suggests that there is still a political risk premium attached to the pound. Thus, if May confirms that the UK government has shifted to a softer stance on EU exit, i.e., a transition deal with virtually full access to the single market and customs union, then we could see this political premium eroded even further. This may pull GBP/USD up towards $1.40, and could send EUR/GBP back towards £0.8500.

We also believe that the market is eagerly awaiting the outcome of May’s speech, which is why the pound has been so quiet over the last few days. Volatility in the 1-week at-the-money GBP/USD option has risen to its highest level since June, although it has backed off recent highs in the last day or so. This spike in volatility suggests that the market is expecting a move in sterling in the coming days, and most likely on the back of May’s speech. Combined with the fact that this speech has a clear binary outcome for the pound, then a surge in GBP volatility on Friday afternoon cannot be ruled out.

Chart 1: 

Source: City Index and Bloomberg

The pound and the FTSE 100 

The inverse correlation between the pound and the UK 100 is alive and well as you can see in chart 2 below. As the pound has recovered in recent days and weeks the FTSE 100 has suffered. If May does suggest that the UK government is taking a softer approach to Brexit then we could see another leg higher in the pound’s recovery. If this does occur then it has the potential to weigh further on the FTSE 100, which has bucked the trend higher in the S&P 500 and recently fell below its 200-day sma, opening the way for a move back to 7,000 if the pound rises on the back of May’s latest ramblings on Brexit.

Chart 2: 

Source: City Index and Bloomberg 

Related tags: Forex Brexit GBP

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