Prime Minister Boris Johnson and the European Union reached a Brexit deal in last-minute talks on Thursday, giving reassurance to the foreign exchange market and a boost to the equity market. But its passage is far from assured, with several immediate hurdles still to be overcome, including what is expected to be a close vote in Parliament on Saturday.
The stunning development followed what had been a whipsaw recent round of Brexit news, starting with Britain’s positive talks with Ireland last week and culminating in the new deal. Buoyed by the goodwill, the pound strengthened throughout the week, allowing the RSM Brexit Stress Index to fall to its lowest point since July. The composite index, which measures financial-market stress surrounding Britain’s impending departure from the European Union, reached below one standard deviation above normal levels of stress. At market close on Thursday, the index reached 0.95 standard deviations above normal, down from the previous week‘s close of 1.07.
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 European Union’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 the Thursday start of a crucial European Parliament meeting. 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 the Westminster Parliament on Saturday. Adding to the pressure, the president of the European Commission, Jean-Claude Juncker, insisted that there could be no extension to the Brexit talks, saying that “it has to be done now.”
The Benn Act requires Johnson to request an extension to the withdrawal period no later than Saturday, Oct. 19, should there not be an agreement before then. With time running out for drawing up a framework suitable for Ireland and the European Union and then getting it through various Parliament factions, 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% 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% 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% 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.