Throughout the long and torturous Brexit negotiations the market in cable never wavered. The bulls bought every dip taking GBPUSD to fresh two year highs as the pair pushed beyond the 1.3600 figure.
- Inflation is the Macro Key
- Inflation is Driven by Supply Side More Than Demand Side
- Can City of London Survive Brexit?
- UK Access to EU Capital Markets in Doubt
- Finance is Far More Important than Fish
- No Love from President Biden
- From Great Britain to Little England?
But now with the Brexit deal signed, sealed and delivered will the new independent United Kingdom prove to be the dynamo of Europe or will the cold hard reality of being on the outside of the world’s biggest consumer market finally start to sink in?
There is one economic variable that will likely determine if Brexit is a boom or a bust but it has been out of view so long, that most market players may ignore it until it’s too late. Inflation. Remember inflation? It used to be an important concept in currency markets but after GFC in 2008 deleveraging, China’s exporting of product deflation and coordinated central bank rate repression have made headline inflation practically obsolete.
Inflation is the Macro Key
The UK has been no exception. Headline CPI has been under 0.5% for the past six month running. COVID lockdowns have only accelerated the trend. But the Brexit deal has put thousands of fresh restrictions on trade between the EU and the UK. Granted most of the new rules simply require paperwork rather than impose tariffs they nevertheless create friction in the process and friction always creates economic costs.
Although the conventional view of inflation is that it is a demand driven phenomenon caused by easy money printing – the truth is actually quite different. If the standard model of inflation was true the G-10 economies would all be in a state of hyperinflation given the money printing over the past decade – but in fact the opposite occurred. Most of the advanced economies have seen disinflation and central banks continue to struggle to push price levels to even approach the 2% barrier.
Inflation is Driven Supply Side More Than Demand Side
That’s because for economies that control their own currency inflation is almost always a supply side phenomenon. It only rears its ugly head when there are true shortages in the system. This is where the Brexit deal could go sideways very fast. The UK is only 61% self sufficient in its food needs. In fact it imports as much as 74% of agri-food products from the EU. If the transition process becomes challenging and friction costs build up in the system, the UK CPI readings could quickly climb above the 1% level.
On the face of it inflation readings at 1%-2% annual rate are generally viewed as benign but in the ultra low deflationary environment of today’s COVID damaged global economy a spike in CPI readings could shackle the UK monetary authorities and frustrate fiscal policy makers as well.
For now, the monetary officials don’t even want to consider the lower bound level with BOE policymaker Sam Woods stating that banks would need to make system changes in order to implement negative rates. But the UK central bank is nevertheless inching towards that line by asking firms to be prepared. The big question will be what will they actually do if inflation rises and demand collapses creating a very unpleasant policy dilemma for which there will be no good solutions
Can City of London Survive Brexit?
While the news focus of the Brexit negotiations has been on the fishery industry – the fate of fish is utterly immaterial to the economic success of the UK. The fish business is a rounding error in UK GDP making up only 0.5% of total economic output. The financial services however is far more important factor in the UK economy responsible for nearly 7% of economic output but even more than that in economic stature as London is considered to be the top financial center of the world. This status has helped attract foreign direct investment in the UK at far greater rate than is merited by its economic output. The key question in 2021 is will London maintain its prominence in finance and therefore allow the UK to maintain its unique place in the world.
UK Access to EU Capital Markets in Doubt
According to the Wall Street Journal, “From Jan. 1, U.K.-based financial institutions lose automatic access to the EU’s single market. To serve customers in the EU next year, U.K.-based institutions will have to be granted equivalence rights, under which the EU allows them to conduct certain financial activities. Equivalence rights can be withdrawn at short notice. So far the EU has granted temporary equivalence rights to British clearinghouses, which operate between buyers and sellers in trades and pledge to complete the deal even if one side reneges. London has much of this financial plumbing, which manages trillions of dollars of derivatives contracts every day.
The sides will continue discussing how to move forward on granting equivalence and pledged to codify a framework for regulatory cooperation.”
Finance is Far More Important than Fish
These negotiations – far more than Brexit itself – will determine if the UK economy can recover and operate smoothly or sink into a depressionary abyss. If the finance sector is hurt by Brexit the UK economy will face a serious shock to the system but neither monetary or fiscal officials could respond in kind if inflationary pressures rise. The UK could face the worst of both worlds – higher prices due to supply chain costs and lower output due to decline of the finance sector. Furthermore, the country would be truly alone with no allies offering to defend its capital markets.
No Love from President Biden
The new Biden Administration is far less accepting of the Brexit project and will likely dissuade the Fed from offering any currency swap lines to the BoE. The Old Lady of Threadneedle Street would have to defend the currency on its own and the UK which runs chronic trade deficits could be under massive speculative attack if the economic situation worsens.
From Great Britain to Little England?
Up to now the UK has enjoyed the historical privilege of being a former reserve currency and the country has experienced massive prosperity by attracting the best talent in EU to participate in more entrepreneurial less bureaucratic finance driven culture while at the same time enjoying unfettered access to the EU market and implicit help and protection of the United States.
Everyone of these variables has been changed by Brexit. The critical question for the near term direction #GBPUSD is – by how much? If both financial and transaction costs begin to rise as a result of the deal the market will have very little patience with the UK assets. That’s why inflation, gilt yields and financial services negotiations will determine if #GBPUSD is 1.40 or 1.30 by middle of next year.