Wednesday, 12 October 2016

Soft Brexit. It's not that hard.

I spent a lovely evening in the company of those who participate in financial twitter. Lovely bunch, A smattering of buy and sell side and a cadre of journalists. But they nearly all had something in common. Mention that you thought Brexit would turn out Ok and you were mostly greeted by stunned gasps.  Laying out a route where it could be OK which involved a soft Brexit along the lines of an adaptive EEA was seen as heresy.

Yet this shock was coming from folk who were 'Remainers'. Surely if they were so in favour of remaining they would support the idea of a soft EEA style exit as preferable to the diamond-hard Brexit that the market is expecting (or rather was, I'll come to that later) rather than arguing vehemently that it wasn't going to happen and instead, all their greatest fears were going to become reality. This was a behavioural clue. These Remainers wanted to remain so badly that getting most of what they wanted through an EEA was just too terrible to think about and they'd rather see Armageddon than see things turn out OK against their protestations otherwise.

So, the basic notion that was being proposed to them went something like this -

 May and Rudd completely messed up the presentation of Brexit plans last week, to the shock and horror of all those in Washington on the IMF circuit, but what they said did not mean that heading down an EEA route was out of the question. Whilst the media got excited about the statement about immigrants only being allowed in if they had a job to come to, this is in effect exactly what Norway has in place at the moment. There is a difference between limiting the flow of needed workers and limiting the flow of all people. In fact, if we look at the Lichtenstein model, which the EU agreed to, Lichtenstein can take up to 90 immigrants a year. Now if you pro rata that up to the UK levels it's about 150k. This is over May's target but eminently fudgeable. Heading down an EEA  route removes the UK from under the jurisdiction of the European Court of Justice and instead parks it under EFTA, which interprets European Law for the non-EU members. So that's the open borders and ECJ issues handled.

More importantly, it is pretty obvious, as the Remain argument has pointed out, that the process of leaving the EU is gong to be long and tortuous and needs a transitional agreement whilst everything gets sorted out. The soft option could easily be accepted by all parties under a transitionary agreement. Why would a soft EEA style, or 'EEA lite', route be accepted by the EU? Supply chains.

Supply chains are so intertwined these days that disruption causes 'butterfly' effects around the world. The 2011 Japanese Earthquake was a case in point. The microchip maker Renesas was knocked out and suddenly the main ingredient to automobile engine management systems was unavailable. Car manufacturing around the globe staggered. Even when you did get a car they were only available in certain dull colours as the paint factories were also out of commission. A hard Brexit will not take out physical supply and the effects of price, with respect to tariffs, can also be adjusted for, but the legal complications are going to take much longer to adjust for. Even if top level Euro politicians may be sounding flat-out against any compromise, those around them know that upsetting the global supply chain is worth avoiding if at all possible.

A handy EEA style package sold as a 'transition' would be sellable within Europe as the UK are seen to be under some EU directive but without the benefits, in other words worse off in EU eyes,  whilst it would be sellable within the UK as the immigration issues will have been addressed (remember we would move to freedom of labour within quotas rather than unlimited freedom of movement of 'people' ) and the UK would be out from under the ECJ.

Now the cunning part would be if someone forgot to add a sunset clause, or expiry date, on the transitional agreement. If the transitionary period went well and everything stabilised it could easily be seen as the new norm and any thoughts towards changing it quietly dropped.

So that was  the basis of this evening's debate.

As mentioned in yesterday's post the world is currently discounting diamond hard Brexit, with the US doing what they do best and missing the nuance. The noise from the States has so many similarities to those expressed during the Eurocrisis. It was black and white, though mostly black. We can also note how the US time zone has seen the biggest legs down in GBP over the last couple of days.  So any hint that the ideas discused this evening may be a possibility should see the pound rise fast. If May's speech caused a 4% drop in pound then that could easily be reversed on glimmers of hope for a soft exit, even if it was wrapped in barbed wire at the Tory Party conference. May and Rudd may have thought that they were just rallying the troops at a non-election year conference but they seemed to forget that the whole world was watching. Yet listen to what they said and none of it is inconsistent with current Swiss of Norwegian conditions.

So, having had this debate in the pub, I get on the train home and see this.

#Newsnight has learned UK govt may be prepared to continue paying billions to Europe to retain access to markets and other rights

Boom. What fantastic timing considering what we had been suggesting in the pub and up goes GBP/USD by 150 points. But considering where we have come from this really isn't much (so far). For me, this is a game changer. Yet the newsfeeds and Twittersphere haven't gone wild over it (yet). Probably because, as I found out at the beginning of my evening, the narrative is for Brexit disaster and the idea of a soft exit doesn't fit with that narrative. Well, guess what? The narrative just changed.

Positons -
Long GBP/USD (added)
Long Oil
Short BTPs
And now short FTSE futures. GBP has rallied and FTSE has hardly budged. FTSE is up on weak GBP and a reversal will see it play catch up with the rest.


Hotairmail said...

Boom. Indeed.

Still feel this won't settle down quite yet. Long way to go. The biggest potential barrier is one of the members playing silly buggers and 2 years runs out. That then becomes your transitional arrangement until new agreements are struck. I give yours an eventual 70% chance versus this a 30% one. But a deal of brinkmanship beforehand. The French may smell blood and push hard.

I guess it is tradable longs and shorts for some time to come as news hits the wires.

Anonymous said...

I was going to say something about the typos in this post, then I saw the reference to having been in the pub, and the time of the post...

Raitis Kalnins said...

why not long gbp/chf? it has sweeter carry than shorting eur/gbp

Polemic said...

Anon.. i ve just started correcting them . But yes.. beer and after midnight!

Polemic said...

Raitis.. the daily swings in gbp swamp carry so would rather keep the trade clean without extra variables for marginal upside.

Celeriac1972 said...

Thank you for this - it's a very interesting and well constructed piece.

Anonymous said...

Hi, What platform are you using to short BTPs?

Anonymous said...

Well, as someone who was in the remain camp, I would prefer soft-brexit - but from where I sit, a very vocal (minority? who knows ) on either side is not that keen on it and is happy to blame the others. The hard 2 year deadline doesn't help either - from that perspective, not invoking A50 is about the only substantial leverage UK has (for some time, anyways). TBH, the rational part from both players would be that UK promised to invoke A50 immediately for EU extending the 2 year period substantially in recognition of the number of agreements that have to be negotiated.

I agree that the supply chains are the major issue, but unlike you I don't see tariffs as the main problem. Tariffs are a known cost. The real problem are standards and Mutual Recognition Agreements. I.e. if you don't have an MRA with EU (and even the famous "just WTO" Australia has one, and it's over 100 pages long), your exports will lag on the border while a sample is taken and inspected. Which can take days for simple things, and I can't imagine how it could work for something like cars or plane wings (Airbus). And I'd say there's no choice in that - the EU custom officials WILL HAVE to do it by law if UK is outside EU and has no relevant MRA. If they don't that's like opening a massive hole in the EU fence through which just about anything can be imported to EU, bypassing any and all EU standards/regulations.

In general, non-tariff-barriers are the ones you need to worry about - just look at Japan. It has no tariffs to speak of (US saw to that), but NTBs keep foreign companies from the Japanese markets very efficiently.

Tariffs are red herring - which is why May's "promise" to Nissan about tariffs is, well, a promise.