Foreign exchange market gives vote of confidence to new Johnson/EU deal

Boris Johnson and the EU reached a new Brexit deal in last minute talks yesterday (Thursday), giving reassurance to the foreign exchange market and a last-minute boost to the equity market. 

The RSM Brexit Stress Index, which measures financial-market stress surrounding the UK’s impending departure from the EU, also dipped to its lowest level since the end of July. At market close on Thursday, the index reached 0.95 standard deviations above normal stress, down from the previous weeks close of 1.07, reflecting a clear destressing through the markets.

Brexit stress index

Simon Hart, lead Brexit partner at RSM, comments: ‘These are extraordinary developments. All appears to now rest on tomorrow’s unprecedented vote in parliament. The new deal’s passage is far from assured. Several immediate hurdles are still to be overcome. In the meantime, our index findings indicate a marked destressing in the markets – how short or long term this downward trajectory remains will become clearer over the coming days. Middle market businesses will do well to track our index as a means to gauging future risk.’

The surprise developments of the past 24 hours followed an index dip last week after talks between Boris Johnson and the Republic of Ireland’s PM Leo Varadkar indicated a ‘pathway towards an agreement’. Though details were not forthcoming, this positive development allowed negotiations to resume in Brussels ahead of this week’s EU Summit. Buoyed by the goodwill, the pound strengthened throughout this week, allowing the RSM Brexit Stress Index to dip below an important milestone. 

Stress in the markets has been receding since Johnson suspended Parliament in the last days of summer, only to be rebuffed by the Supreme Court and members of his own party. Those domestic setbacks to Johnson’s do-or-die rhetoric surrounding Brexit were quickly followed by the EU’s dismissal of Johnson’s initial withdrawal proposal as being unspecific and unworkable for Ireland, while leaving the door open for further negotiations. 

Those negotiations occurred on Tuesday and Wednesday, with the slim prospect of a legally acceptable agreement being available for this week’s crucial Summit. Moreover, sign-off ahead of the summit suffered a setback Thursday morning when Northern Ireland unionists of the Democratic Union Party announced that they could not support the draft agreement in its current form, a significant obstacle to getting through Parliament tomorrow. Adding to the pressure, the president of the European Commission, Jean-Claude Juncker, insisted that there could be no extension to the Brexit talks.

The Benn Act requires Johnson to request an extension to the withdrawal period no later than Saturday, should there not be an agreement before then. With time running out for drawing up a framework suitable for Ireland and the EU and then getting it through Parliament, an extension of the withdrawal period looks to be the most prudent option and the one most likely to be calming for the markets. That leaves an indeterminate amount of time for some degree of financial and economic uncertainty to continue. 

Performance of index components

The RSM Brexit Stress Index is made up of six components; they include the British pound-euro exchange rate and its volatility, the FTSE 100 and its volatility, the gilt yield spread and the U.K. corporate bond spread.

The pound strengthened for the second week versus the euro, regaining 0.8 per cent of its value on lower volatility while gaining 4.0% against a basket of its trading partners. Nevertheless, the pound’s loss in value since the onset of Brexit fever in April 2015 will most likely contribute to the strain on household balance sheets and subsequent economic growth. 

The FTSE 100 moved lower during the first three days of the week, dropping 1.4 per cent within a pattern of lower highs and lower lows. But that pattern was apparently broken by Thursday’s news of a Brexit breakthrough, leaving the equity market 0.9% below last week’s close. Volatility could be expected to remain higher than normal until the Brexit details are reasonably sorted out.  

The yield on 10-year gilts moved 2 basis points lower to end Thursday at 0.69 per cent and the yield curve remains inverted, anticipating a slowdown in growth in the months ahead. The corporate market was slightly more optimistic, with the spread over gilts lower by 2 basis points. 

The RSM Stress Index tracks six variables:

1. British pound/euro exchange rate
An exchange rate measures expectations of relative interest rates and the demand for one currency relative to another due to trade and current account flows.

2. Volatility of the British pound/euro exchange rate
Low volatility suggests a stable environment in which to make investment or trade decisions. A spike to high volatility indicates uncertainty in the market.

3. Equity market performance
In the absence of shocks, stock indices show a tendency to grow over the years. We look at the weekly level of the FTSE 100 Index relative to the same week of the previous year.  

4. Equity market volatility
Spikes in the volatility of the FTSE 100 suggest the potential of a shock and an environment of uncertainty. 

5. Yield curve spread
A steep yield curve indicates the market expects sustained, long-term growth. A flat yield curve indicates the market is expecting low levels of growth.

6. Corporate yield spread
The corporate yield spread measures the risk of holding a corporate security versus the safety of a risk-free government security. The higher the spread, the more the perceived risk of economic distress and the prospect of corporate defaults.