Financial markets are totally unprepared for the prospect of a so-called “hard Brexit” and have not even remotely priced it into their models, according to new research from Deutsche Bank.
In a note titled “A hard Brexit isn’t remotely priced” and circulated to clients on Wednesday, Deutsche macro strategist Oliver Harvey argues that markets simply aren’t ready for the scenario whereby Britain would pull out of the European single market, which in turn would allow the government to end the free movement of people.
That situation is being dubbed a “hard Brexit.”
Harvey’s argument is that markets are currently ready for the UK to leave the EU in what he calls a “benign” scenario, where it keeps single market access in some respect, and does not need to negotiate trade deals with countries all over the world.
That basically means that if a hard Brexit does materialise it is going to be a huge shock, potentially making any market moves — particularly with regards to the pound — more extreme than they might be otherwise.
As Harvey writes:
“If this suggests the market was anticipating a relatively benign outcome from the UK’s forthcoming renegotiation, political developments from the Conservative Party Conference this week will have come as more of a shock.
“Hard Brexit has become a meaningful risk, with Prime Minister May tying herself to a deadline of end March 2017 to trigger Article 50 and prioritising immigration and sovereignty from the ECJ — both incompatible with continued Single Market membership.
“Our takeaway from the conference was that May believes the threat of rebellion from hard-line eurosceptic Conservative MPs is significantly greater than from the more centrist wing of the party or a divided opposition — the corollary being a much tougher negotiating stance. The risk is that this does not play well with EU partners, particularly given French and German elections next year.
“With political risks growing and much of the flow impact yet to be felt, we remain bearish sterling.”
Markets being unprepared for a Brexit scenario is not exactly new, as it is essentially what occurred on the night of the Brexit vote. The vast majority of market participants were pretty much certain that Britain would vote to remain in the EU, and had priced that in.
Minutes before the first votes came in, markets were pricing a near 100% chance of a remain vote, so when it turned out that Britain actually voted to leave it was a monumental shock, causing assets across the board to plunge lower.
Unfortunately for the markets, it looks as though a “hard Brexit” is becoming the likely outcome once the government starts negotiating the UK’s exit once Article 50 is triggered early next year. Hints are coming left, right and centre from within government that controlling immigration is a higher priority than single market access
“If you look at the referendum, it’s very clear that the public wanted an end to uncontrolled migration. That was the clear message and we have to accept that,” Trade Secretary Liam Fox said at a fringe event of the Conservative Party conference earlier this week. “If you ask the British public whether they think migration can be a good thing, generally they will say yes.”