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.
It would take a lot for the market to change its “Brexit bias. The market has found it easier to believe in the downturn in the UK as a result of the referendum result rather than the more optimistic story when the data surprises were turning positive in its aftermath. When the data positively surprised consensus in the first few months after the vote, the GBP failed to rally meaningfully. In fact, any bounce in GBP after a good data release was often used to sell at better levels.
Although certain “flashpoints” during the Brexit negotiations will continue to move the pound, it will take a lot to materially change the market’s “Brexit bias”.