Irish Border and Magical Realism

ireland
The Irish border is one of the most intractable challenges of Brexit.  There is not easy solution and the political configuration makes it even more difficult.  UK has local elections next month before the Withdrawal Bill is voted on in the House of Commons.  Meanwhile, speculators are taking a substantial bullish position in sterling.

The UK says it will leave customs union on in a year’s time. However, it also says it accepts that there cannot be a hard border between Northern Ireland (part of the UK) and the Republic of Ireland.    Nor can the hard border be placed between Northern Ireland and the UK.  The Democratic Unionists of Northern Ireland have given Tory Prime Minister critical support in Parliament.

Although many see EU negotiators playing hardball with the UK, they have allowed negotiations to proceed even though the Irish border issue remains unresolved everywhere but in theory.  The UK is pinning its hopes on a technological solution, that when first suggested was dismissed by EU negotiators as “magical thinking.”

The UK proposed two solutions.  The first is a “streamlined customs union” which would still require border checks but softer in nature.  The second, and that is what is drawing attention, is for a customs partnership.  The UK would 1) be able to track the destination of all goods that enter the countries, 2) it would collect duties on goods that are headed to the EU and send the funds to the EU, and 3) would collect other duties for goods that stay in the UK.

The key is a tracking technology that can accurately identify the final destination of all goods.  Although not familiar with all the technology available, part of the logistical challenge is that trade in semi-finished goods or components by cross national frontiers more than once.    It would be much easier if the UK simply stayed in the customs union or committed to retaining the EU’s regulatory standard.  Yet both sit ill with the Brexit camp.

Singapore is regarding as the best in the class in deploying technological solutions for customs.  Estimates suggest that it could take the UK five to seven years to adopt and implement a similar program.  The UK seems to lack a sense of urgency.  In contrast, for example, the Dutch have reportedly hired 750 new officials in anticipation increased activity.

The UK’s decision to leave the EU is not the cause of the increased tensions in Irish politics but it contributes.  The power sharing arrangement facilitated by the Good Friday Agreement (1998) has broken down.  The Irish election in 2016, where Fianna Fail and Labour was trounced, took place four months before the UK’s Brexit vote.   Irish politics are precarious and the UK withdrawal from the EU will change a finely tuned balance.

While the Irish border is a particularly vexing issue, there are other near-term challenges as well.    The UK local elections are a month away as of today (May3).  The local elections are in England, not in Scotland, Wales, or Northern Ireland.  As in the US midterm elections, the governing party tends to lose seats local elections.  In 2014, the last local elections in England, Labour did well, picked up six councils and 300 councilors.  The Tories lost 236 councilors and 11 councils.

One implication is that Labour has more seats and councils to defend than in 2014.  London appears to be a key battleground.  Labour had done well in last year’s national election and reports suggest it may give the Tories a run for their money in their traditional Conservative strongholds of Wandsworth, Hillingdon, and Westminster.  The Tories may be pressed in a few other council contests (Barnet, Kensington, and Chelsea) according to reports, but may regain a few that had been previously lost.

A substantial loss by the Tory Party could spur a leadership challenge.  However, Prime Minister May’s support seems to have risen since the confrontation with Russia.  However, while May might dodge that bullet, another challenge awaits. Sometime after the local elections, the House of Commons is expected to vote on the Withdrawal Bill.  It is a close call, and a defeat for the government could topple it.  The Withdrawal Bill appears to undermine the devolution enjoyed by Scotland and Wales.  We note that the event market, PredictIt, has a 72% chance that May remains Prime Minister through the end of the year.

Sterling is among the better performing currencies so far, this year.  Its 3.85% gain trails only Norway’s (krone) 4.7% increase and the yen’s 5.85% rise.   It is up 12.4% over the past 12 months, trailing only the euro’s 14.9% gain (Denmark tracks the euro closely and is up 14.7%).   Sterling has been in a $1.40-$1.41 range today and the past three sessions.  A convincing break of the base, which may extend to $1.3980, would suggest initial potential toward $1.38.  On the upside, March ‘s high was set near $1.4250 and this is the last hurdle ahead of the January 25 high (~$1.4345), which was the best since the referendum.

Speculators in the futures market like sterling.  The net long position of 34.2k contracts, as of the March 27, is the largest in three years.   The gross longs increased by nearly 50% since the start of March (from 61.4k to 90.2k contracts). The gross shorts fell to a two-year low in late March near 47.6k contracts, half of what it was six months ago.

We note that in the cross-currency basis swaps (three months) sterling earns a premium over LIBOR, the most in at least a decade.  The market has grown more convinced that the BOE will hike rates next month.   A combination of data, official comments, and that two MPC members dissented last month in favor an immediate hike appears to have been persuasive.  The OIS curve implies almost an 80% chance is discounted.  The market leans toward another hike in Q4.