Brexit breakthrough?

Chris Scicluna
Emily Nicol

While nothing of substance has yet emerged from either set of negotiations, positive mood music yesterday related to US-China trade and Brexit has given a timely boost to market sentiment. Certainly, President Trump appeared relatively upbeat about the trade talks, judging that “We’re doing very well” and that “China has been very nice”(!). He will meet at the White House later today with Vice Premier Liu He. And while there’s no evidence of a meaningful shift in China’s position on technology transfer and state aid, those comments raised hopes of an announcement to postpone, or even cancel, the 5ppt increase in US tariffs, to 30%, on roughly $250bn of imports from China currently scheduled for Tuesday.

So, after yesterday’s gains in US markets (the S&P500 closed up 0.6% and futures are pointing higher again today), Asian markets followed suit led by Hong Kong, where the Hang Seng rose 2.3%. With the yuan up to its strongest level in three weeks, close to 7.10/$, China’s CSI300 closed up 1.0%. And as the yen depreciated to 108/$, the weakest since last week’s dire US manufacturing ISM report, the Topix closed up 0.9%, even as a BoJ survey suggested that about two-thirds of households plan to cut spending in the aftermath of last week’s consumption tax hike (see below).

In bond markets, meanwhile, USTs are broadly stable after yesterday’s sell-off, e.g. with 10Y yields above 1.64%, up about 8bps from this time yesterday and close to the highest in nine days. And ahead of Monday’s Japanese national holiday, and while Governor Kuroda remained non-committal about the outcome of the end-month Policy Board meeting – repeating that the BoJ had several options to ease policy further but would be very mindful of possible adverse side-effects – JGB yields moved higher across the curve, with 2Y yields up about 2bps to -0.30% and 10Y yields up 2½bps to -0.19%.

Of course, euro govvies already sold off yesterday. And so, despite a jump in the price of Brent crude of more than $1 to above $60 per barrel this morning on reports of an alleged missile attack on an Iranian oil tanker travelling through the Red Sea, Bunds and their peers are a touch firmer this morning (e.g. 10Y Bund yields down about 2½bps to -0.50%, still however about 5bps higher than this time yesterday.

Gilts are only a little firmer, leaving 10Y yields close to 0.57%, up about 11bps from yesterday. And sterling is still close to $1.245, having yesterday jumped more than 2% – its fourth biggest one-day gain in a decade – after the joint statement from yesterday’s tête-à-tête between UK Prime Minister Boris Johnson and the Irish Taoiseach Leo Varadkar insisted that “they could see a pathway to a possible deal” even as they offered little reason to believe that they much closer to agreement on the knottiest of issues: how to allow for Northern Irish consent to a deal and what should be the customs arrangements between Northern Ireland and the Irish Republic.

So, after yesterday’s Varadkar-Johnson meeting, all eyes today will be on Brussels where UK Brexit Secretary Stephen Barclay is currently meeting with the EU’s chief negotiator Michel Barnier, who will subsequently brief EU Ambassadors and try to develop an updated EU position. If there is an announcement later today that negotiations will be intensified over coming days in the so-called ‘tunnel’, then expect sterling to gain a further boost before the weekend.

Quite how far Johnson has moved, however, remains to be seen. There is frequently a mismatch between the UK PM’s words and deeds. Indeed, Johnson has a habit of saying one thing to one audience and the opposite to another. And with reports suggesting that ahead of the meeting Johnson cleared his position with Arlene Foster, leader of the hard-line DUP, the shift in UK position might be modest.

Moreover, it is possible that yesterday’s event was little more than theatrics, staged to allow both sides to try to avoid the blame if and when talks eventually collapse. Alternatively, the suggestion of a ‘pathway’ to a deal might have been made to allow Johnson to avoid losing too much face if and when he is forced to write a letter to the EU requesting an Article 50 extension after next week’s EU summit. Certainly, it still seems hard to believe a deal could be reached at the summit, endorsed in the House of Commons and European Parliament, AND all the necessary implementing legislation adopted in time for the UK to leave the EU in an orderly fashion on 31 October.

Nevertheless, it is possible that, as hinted at in the Taoiseach’s press conference and subsequent anonymous media briefing from Irish officials, Johnson has indeed made a meaningful shift in position, and perhaps even offered coherent ‘off-the-shelf’ proposals on consent (based on the so-called ‘double majority’ principle) and customs. This latter issue remains most troublesome, however, given the difficulty of squaring the circle between Johnson’s insistence that Northern Ireland withdraws from the EU Customs Union (thus keeping the UK intact for customs purposes) and the previous UK commitment to avoid physical customs infrastructure at the Irish border. But it’s possible that Johnson has suggested an amended version of one of Theresa May’s maligned proposals – the so-called customs partnership – albeit limited only to Northern Ireland.

According to this concept, the UK would agree to enforce EU customs rules and tariffs on goods moving from Great Britain to Northern Ireland. But if the EU tariff was higher than the UK tariff on the goods concerned, Northern Irish firms would subsequently receive a rebate. In other words, while Northern Ireland would be out of the EU Customs Union, the border for administrative purposes, like that for regulatory purposes under Johnson’s proposals, would run down the Irish Sea.

Of course, such plans might struggle to gain the support of the DUP and more nationalist members of the Conservative ERG. So, while the EU might agree to them, they could struggle to find a majority in the House of Commons, unless, perhaps, they were approved subject to confirmation in a second Brexit referendum. So, with less than a week to go to the make-or-break EU summit, a range of Brexit scenarios and outcomes remains feasible.

While the past week’s August consumption-related figures already provided some evidence of front loading of spending ahead of the consumption tax hike (albeit so far to a lesser extent than in the run up to the 2014 tax increase), today’s BoJ consumer opinion survey suggested that around 37% of households had brought forward certain purchases ahead of the tax hike compared with almost 41% in 2014. According to the survey, electrical appliances again topped the list of those goods that households had front-loaded spending on in September at 46%, followed by daily necessities (32%), autos (21%) and clothing (16%). Perhaps unsurprisingly, the share of households expecting to decrease their spending after the tax hike was high, at almost 70% and little changed from the equivalent in March 2014 before the last tax hike.

Among other detail in the BoJ survey, households were also more negative about their financial situation given some lower summer bonus payments this year. And they saw a further deterioration in income prospects over the coming year too, with the share of those forecasting a decline (37%) the highest since March 2016. They were also more downbeat about current economic conditions compared with a year ago, with the survey’s DI falling 1pt to -26.0, its lowest since June 2016. And perhaps predictably given the tax hike and the more challenging external environment, they expected a further notable deterioration in economic conditions over the coming twelve months too, with the relevant DI down 5½pts to -41.7, the lowest since 2008. Overall, today’s survey tallied with the Cabinet Office’s consumer confidence survey, which has reported a deterioration in sentiment in every month this year (and hasn’t posted an improvement in any month since November 2017). And it is seemingly at odds with the BoJ’s persistent optimism that robust domestic demand will keep Japan’s economy on a moderate expanding trend.

Euro area:
A relatively quiet day for euro area economic news has this morning seen the release of final German and Spain inflation figures for September. These provided no surprises, e.g. with headline German CPI on the EU-harmonised measure aligning with the flash estimate showing a decline of 0.1ppt to 0.9%Y/Y, the lowest since November 2016. The downward pressure principally reflected weaker energy price inflation, which posted the first negative reading since mid-2017, while food inflation also moderated. But while non-energy industrial goods inflation also slipped back to a six-month low (down 0.2ppt to 0.9%Y/Y), services inflation ticked higher (up 0.5ppt to 1.2%Y/Y). As such, core inflation took a step up in September, up 0.2ppt to 1.0%Y/Y, nevertheless remaining below the average of the past two years and suggesting still very subdued underlying inflationary pressures.

The equivalent Spanish figures also aligned with the preliminary release showing headline inflation falling 0.2ppt to 0.4%Y/Y in September. Like in Germany, the weakness largely reflected a steeper decline in energy inflation, with the 6.5%Y/Y drop the steepest for more than three years. Having increased to the highest since the start of 2017 in August, non-energy industrial goods inflation also slipped back (down 0.1ppt to 0.5%Y/Y). But with services inflation up 0.2ppt to a five-month high of 1.7%Y/Y, core inflation was unchanged at 1.1%Y/Y, suggesting that underlying inflation remains subdued but not quite as weak as the headline index might imply.

Beyond the data, ECB Governing Council members de Guindos and Hernández de Cos will speak publicly at an event in Madrid later this morning.

In the US, while all attention will be on the trade talks, the data-flow bring the import and export price indices for September, as well as the preliminary University of Michigan consumer sentiment survey for October. With respect to Fed-speak, Kashkari, Rosengren and Kaplan are due to speak publicly.

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