Squaring the Circle: Can Article 7 be Used to Force Article 50?

Due to an unlikely string of events, the UK had sorted out its government more than two months quicker than it had looked likely in the immediate aftermath of the referendum when Cameron resigned.  However, to the frustration of others in the EU, May not only named Johnson, who insulted nearly every country, as the Foreign Minister, indicated she is in no hurry to trigger Article 50 of the Lisbon Treaty that formally begins the negotiations of the separation.

If a UK referendum must be held, European officials wanted it to continue as a member of the EU.  Now that is has been held, and the vote was to leave, European officials want to begin the process as quickly as possible.    Cameron had initially provided a basis for such expectations.

May has thrown a new precondition into the mix.  May says that Article 50 will not be triggered until Brexit has Scotland’s backing, and Scotland is not prepared to give it.  It is one of the few areas in the UK that voted to remain in the EU.    In the Clinton Administration in the 1990s, there was a debate about what the word “is” meant.  Now, what May means is being discussed.

The timing of Article 50 is entirely in the UK’s hands (there is a legal debate about the role of Parliament in the decision), but once triggered the negotiations favor the EU.  After all, it is an EU Treaty, and it was designed to make for a high and costly barrier to exit.    Is there a way that the EU could pressure the UK into a more timely beginning of the negotiations?

The Lisbon Treaty has various clauses that can be used to bring a country to heel.  Article 7 allows the voting rights of a member to be suspended for not cooperating in good faith.     It is seen as a very aggressive step and is unprecedented.  The lack of precedent did not prevent the EC from entering into talks with Poland about some measures that raised questions over its commitment to democratic institutions or presently debating levying fines on Spain and Portugal for not trying harder to meet their fiscal goals.

Even without triggering Article 50, the UK’s influence in the EU has already begun to wane.  A UK representative is no longer the EC Commissioner of financial services.  The UK was scheduled to assume the rotating presidency in H2 1,7, which no longer looks tenable.  There have already been meetings to which the UK is not invited.

On the other hand, the signal that other UK officials are sending suggests Article 50 will be triggered either late this year or early next year.  In an attempt to ease business concerns, the UK’s new Trade Minister Fox indicated that there would be around a dozen free-trade agreement ready for the UK exit from the EU by 1 January 2019.

Although the leadership of the BOE’s MPC has signaled that it is devising a package of measures that will be ready next month, Weale, among the more hawkish members, suggested he wanted to see real sector data before easing policy.   Note that Weale’s term end on August 8, a few days after next meeting.   He is reportedly going to take an academic post at King’s College in London.

The challenge is that the BOE meets again August 4.  The quarterly inflation report and updated forecasts will be available at the same time.  There will be very little real sector data for the post-referendum period. To this end, Markit has decided to publish a one-time only flash UK manufacturing, service, and composite PMIs (July 22).

However, still in the realm of surveys, Deloitte polled 132 CFOs of UK companies five days after the referendum.  As one could guess, there was a sharp rise in uncertainty and risk-aversion from the last survey, three months prior.  Nearly three-quarters of the CFOs said they were less optimistic about their firm’s financial prospects, which represents a more than doubling from the earlier survey. A little more than 80% expect to reduce capital spending over the next 12-months and reduce hiring.  Both numbers more than doubled.

The IMF is likely to reduce its growth forecast for the UK later this week as part of its mid-year estimates.  It would be the third cut in its global forecast.  This year’s growth was estimated at 1.9% in April and 2.2% in 2017.  The IMF, like many economists, have warned that Brexit would have a substantial and negative impact on the UK economy.

One key issue for banks and asset managers is whether the UK will be able to maintain access to the single market without having to keep its borders open to migrants from the EU.  A new set of rules and regulations (MiFID II) will come into effect at the start of 2018.  It allows banks in non-EU countries to service customers in the EU provided that their home country’s financial rules were equivalent to the EU’s regarding strictness and scope.  UK rules would likely meet this requirement.

While this sounds promising, there are three catches.  First, it is, of course, untested.  Second, and more importantly, while banks might be able to use MiFID II, some of their most important clients, euro-denominated asset managers, have not equivalent “passport” rights.    Third, while there may be equivalency between UK and EU bank rules and regulations, they are subject to change.  Going forward, not all the EU changes can be assumed to be to the UK’s liking, and this may put it in a difficult position.

Sterling’s low against the dollar and euro were recorded on July 6.  It reached a low just below $1.28.  The euro reached a high a little above GBP0.8625.  Sterling has been consolidating is losses since.  In this consolidation, sterling firmed to $1.3480, and the euro pulled back toward GBP0.8250.    The 38.2% retracement objectives are found near $1.3645 and GBP0.8205 respectively.

In the days before the referendum, the UK offered around 105 bp more than Germany on two-year paper.   It is now less than 82 bp.  From early June until the referendum, the US two-year premium over the UK was halved from 50 bp to 25.  The combination of expectations of BOE easing and the strength of recent US economy widened the spread to 55 as of last week.  It is a little lower today.

The UK premium over Germany on 10-year money has also narrowed dramatically but is has been falling since mid-April.  It peaked near 137 bp on April 22 and fell to a low of 82 bp last week.   It is consolidating today.   The premium the US offers over the UK is still growing.  It stands near 77 bp today, the most since 2000.   It was around 46 bp at the beginning of June.