Tensions between the EU and Britain over the Protocol on Ireland/Northern Ireland could create potential headwinds to the British currency. The pound fell last week following the Bank of England's decision to keep interest rates unchanged, and markets are now putting their hopes on a February hike. However, any upside potential will be hindered if the EU and the UK do not resolve their disagreement. Already, the EU has issued warnings if the UK triggers Article 16 of the Irish Protocol, while fears of a trade war between the two are growing stronger.

On Wednesday morning, Tánaiste Leo Varadkar warned British prime minister Boris Johnson that triggering Article 16 would be a “very aggressive and bombastic move” and noted that the UK will not end up with a better deal by doing so. Varadkar said: “The message I’d send to Boris Johnson is that we have an agreement in relation to Northern Ireland, we have an agreement in relation to trade with the European Union - don’t jeopardise it.” He added: “You were part of negotiating it, you own it, it was hard won, it’s a mistake to think that by escalating tensions or by trying to withdraw from any part of it, that you’ll end up with a better deal: you won’t.” Triggering Article 16 would allow the UK to suspend all, or part, of the treaty and will undo the Brexit deal resulting in the collapse of relationships.

Foreign exchange markets could build a premium into Sterling exchange rates as uncertainties over the future trading relationship between the UK and EU continue, posing considerable risks to the currency.

What is Article 16?

Article 16 is a clause in the Protocol on Ireland/Northern Ireland, which is an important part of the Withdrawal Agreement. The Protocol was created in order to avoid a hard border between British-ruled Northern Ireland and EU member Ireland by introducing some checks on the movement of goods to Northern Ireland from mainland Britain. Article 16 allows the UK or the EU to take action if they believe the Protocol will lead to "serious economic, societal or environmental difficulties."

The EU has cautioned Britain that triggering Article 16 would hurt relationships with the EU and destabilise Northern Ireland. By reopening the Protocol will create further complications regarding peace in Northern Ireland and protecting the EU's single market.

Brexit troubles will hurt the pound

The tensions between the EU and the UK and the prospect of a trade war over Northern Ireland will create potential risks to the pound. Financial analysts and strategists are cautious and believe the pound will trade with a more defensive tone as markets expect the UK government to trigger Article 16 of the Northern Ireland Protocol during the second half of November.

Markets will also be watching Friday’s meeting between the chief negotiators David Frost and Maroš Šefčovič.

Brussels Correspondent for BBC News, Jessica Parker, has reported that according to an EU diplomat the talks are rumoured to have been "extremely bad".

A worst-case scenario for the Pound would be the complete termination of the post-Brexit trade agreement, but this will be unexpected and a very extreme scenario. More likely, the EU could trigger legal proceedings and potentially impose tariffs on certain goods.

 

 

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The pound is not expected to rise higher from current levels, analysts have said.  Brexit tensions and an early interest rate hike by the Bank of England could eventually push the pound lower. Barclays warned of possible Brexit tensions rattling the foreign exchange market, while HSBC analysts said that the pound is not cheap and that there are significant risks to the UK outlook.

HSBC analysts

HSBC currency analysts believe that the pound should have been higher than current levels, considering market expectations for an earlier rate hike. The fact that the British currency has failed to advance despite these developments, suggests that political risks are returning to the currency.

HSBC analysts do not see scope for further Sterling gains, as the pound faces opposing forces including growth, inflation, rate expectations and external balances. They argue that the pound’s trajectory will become clear once one of these forces dominates the other. The bank said that Sterling could gain in the near-term due to the Bank’s expected rate increases but this would be offset by a deteriorating economy as the Bank’s monetary tightening fades quickly. The high energy costs combined with higher inflation will slow economic growth, the analysts added.

  • Brexit vote and financial crisis

HSBC noted that the pound has been deeply affected by the Brexit referendum in 2016 and earlier by the 2008/9 financial crisis. Both events have influenced the fair value assessments of the pound and they argue that currently the UK currency is closer to fair value and even expensive against other currencies.

  • Inflation

HSBC bank notes that the UK is expected to grow at a slower pace while exhibiting the highest inflation in over a decade, with fears of stagflation hurting the pound. In a survey conducted by Barclaycard, 90% of the shoppers said they were concerned that rising costs of everyday items would affect their household finances.

Barclays

Barclays analysts are also concerned with the pound outlook as they have pointed out that tensions between the EU and UK over the Northern Ireland protocol could negatively impact on the foreign exchange market. Failure to reach an agreement might result in the UK triggering Article 16 of the protocol, triggering retaliation measures by the EU such as tariffs and impacting on the Trade and Cooperation Agreement (TCA). Any such scenarios will hurt the pound.

Britain wants to negotiate a “new protocol” to regulate post-Brexit trade in Northern Ireland, Britain’s Brexit Minister David Frost said in Lisbon on Tuesday. Ahead of the European Commission's formal response to the UK’s plan, Lord David Frost said the EU would be making a “historic misjudgement” if it refused to rewrite the Brexit deal covering trading arrangements for Northern Ireland. Brussels has warned the UK that they are not in a position to indulge themselves in important renegotiations.

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The outlook for Sterling will remain at risk as market analysts are cautious for the UK currency, especially with the new week having started with further pound declines.

Bank of England policy meeting

While the pound has enjoyed gains in the beginning of the new year and until recently, analysts are slowly becoming more cautious following last week’s sharp decline with traders less confident in the currency. Therefore, traders will focus on this week’s Bank of England policy meeting on Thursday for some direction for Sterling. If the Bank of England's Monetary Policy Committee delivers a more hawkish than expected message then the pound could regain some of its recent losses against the US dollar, analysts believe. On Thursday, the Bank of England will provide their latest assessment on the UK economy but is not expected to take any action and it will leave interest rates unchanged. It will be in August’s policy report that any possible major changes in the Bank’s direction will be announced, and the market will focus on such expectations and whether economic recovery will drive the Bank to change interest rates next year. If the Bank reveals any signs that it is going to move towards this direction, then the pound might be lifted by the end of the week.

Potential dangers for the pound

Some analysts believe that much of the positive news is already priced in and that the pound will be vulnerable to downside moves if economic data disappoints. It has also been noted that we should be more optimistic as the pound has responded rather well to economic data, but that currency risks are indeed real and could potentially hurt the pound. For example, there are currency risks related to the futures market as there are traders who are holding long positions—meaning they have purchased Sterling and are waiting for the currency’s price to go up—and when those positions are undone and the pound is sold, they will expose the pound to a fall.

There are also risks regarding the pound’s performance and the loss of momentum. The Sterling 2021 rally has now stopped, and this is a possible reason for concern.

Another possible reason for concern is the rising tensions between the UK and EU and a potential trade war about the Northern Ireland protocol. The EU has threatened the UK with tariffs on UK exports if Britain fails to implement the Northern Ireland protocol. Analysts remain cautious as discussions continue and further potential challenges arise. It was announced last week that the UK government requested from the EU the suspension of some elements regarding the Northern Ireland protocol until October, while they strive to reach an agreement on transporting chilled meat products from Great Britain to Northern Ireland. Any news regarding tensions between the UK and EU on the Northern Ireland protocol could trigger Sterling volatility.

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Brexit is back in the picture, as there are talks of a potential trade war between the UK and EU over the coming days after both sides failed to reach agreement on the Northern Ireland protocol. The EU has threatened to impose sanctions on UK exports to Northern Ireland if it fails to implement the terms of the Northern Ireland protocol next month. If things escalate, the pound will also be affected, as it usually falls when concerns around Brexit rise.

EU press conference

On Wednesday, UK and EU officials met in an attempt to resolve any disputes over trade rules for Northern Ireland. In the EU press conference following talks with Lord Frost on Northern Ireland protocol, Maroš Šefčovič, the vice-president of the European Commission who serves as the EU’s lead on post-Brexit negotiations with the UK, said that fundamental gaps remained in the UK’s implementation of the deal. On the Northern Ireland protocol, both sides agreed in 2019 this was the best solution to protect the Good Friday agreement. In December last year some solutions were agreed, including grace periods and exemptions in areas where the UK was not ready to implement the protocol. But he highlighted that “we cannot undo the core of the protocol”, as there are still “numerous and fundamental gaps” in the UK’s implementation of the deal.

He also confirmed that the EU could take retaliatory action. Šefčovič says the EU is a peace project, and, as he said, he did not arrive with a list as he is looking for a solution. But he did confirm that the EU could impose tariffs on some UK goods if the Northern Ireland protocol was not implemented. The protocol is designed to prevent checks at the border with Ireland. So, the EU agreed to let the UK conduct these checks at the GB/NI border. The easiest thing would be for the UK to accept EU SPS standards. Nonetheless, Šefčovič says he has a good and honest relationship with Frost and believes in Frost’s “best intentions”.

How will the pound react?

If the relationship with Brussels breaks this could weigh on Sterling sentiment in the short-term. If the EU does take any retaliatory action, and tensions escalate, then the possibility of the UK losing access to the single market would raise significant risks for the UK economy and hurt the pound.

The Prime Minister’s spokesman said: "The protocol was formed in a spirit of compromise, in challenging circumstances. It was not a finished solution... and we didn't expect the EU to take such a purist approach to it. We are working very hard to resolve these issues consensually. But the Prime Minister has always made clear we will consider all our options in meeting our responsibility to sustain peace and prosperity in Northern Ireland.”

Are you transferring funds abroad?

If you are a business transferring funds overseas, contacting a currency specialist could save you time and money. Get in touch with Universal Partners FX and their dedicated team to discuss the latest market movements ahead of your currency exchange. If you are transferring funds to pay your employees abroad, get in touch with Universal Partners FX to find out how much you can save in your international money transfers. Universal Partners FX can provide invaluable help on efficient risk management and tailored solutions to your business’ transfer needs.