Now the election campaigning is over, “Brexit” is returning to the headlines. Whether it’s a hard, soft, cliff-edge or smooth Brexit is still to be clarified. There are so many versions of Brexit, that defining what “hard” or “soft” Brexit means is a conversation in itself. While “Hard vs Soft” has become the standard classification of Brexit, it lacks nuance. George Buckley, Chief UK Economist, Andy Chaytor, Head of European Rates Strategy, and Jordan Rochester, FX Strategist, attempt to demystify what a hard or soft Brexit actually mean and its impact on markets.
The Brexit spectrum
Without more clarity on what hard or soft Brexit actually mean, we have developed a five-level system that shows an array of possible outcomes of the UK leaving the EU, from what might be deemed the softest (labelled “1”) to the hardest (“5”).
The softest Brexit we argue is a deal, whereby the UK leaves the EU on good terms and remains a member of the Single Market (though not the Customs Union) in much the same way Norway is a member of the European Economic Area (EEA). On the other end of the spectrum, the hardest Brexit would be a complete breakdown of talks between the UK and the EU, with no deal in place – either transitional or a long-term free trade agreement (FTA). The UK will then revert back to World Trade Organisation (WTO) tariff schedules to govern its access to European markets.
What does this mean for investors?
A very soft Brexit should see a significant rise in yields, back to roughly pre-Brexit levels. However, the harder the Brexit, the less yields rise / more they fall. The exception to this is the hardest Brexit . We see this as so damaging to the perception of the UK that the fall in GBP and potential concerns about credit worthiness actually sees UK yields rise.
We think the market has largely priced in the difficulty of the early stages of the Brexit negotiations already. There may be certain “flashpoints” during the actual negotiations, be it a “walkout” from either side during dinner talks or strongly worded political speeches; however, it will take a lot to materially change the outcome assuming both sides remain pragmatic.
Overall, we think the potential for the GBP to depreciate further is limited for the following reasons:
1) The inflation premium in GBP is starting to look over-stretched;
2) the Bank of England may start to become less pessimistic;
3) ihe difficulty of the early stages of the Brexit negotiations looks to be priced in already;
4) A “soft Brexit” is more likely as markets will interpret this general election result as a rejection of Mrs May’s tough stance in the upcoming negotiations with the EU.