Are markets underpricing the risk of no Brexit deal?

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Markets May Be Underpricing the Risk of a No-Deal Brexit

Recent market sentiment indicates a high probability of a post-Brexit trade deal between the UK and the European Union, with expectations for an agreement hovering around 80-85 per cent. This optimism is reflected in the pound's performance, which has remained near recent highs against both the dollar and the euro. However, analysis from financial institutions suggests that the market may not be fully accounting for the potential downside if negotiations fail, leading to a scenario where a lack of a deal could trigger a more significant market shock than currently anticipated.
High Expectations for a Deal Persist

Traders and analysts have grown increasingly optimistic about the likelihood of a trade agreement being reached before the December 31 deadline, when Britain formally loses access to the EU's customs union and single market. This sentiment has driven the pound to gain against the dollar for four consecutive days prior to the reporting period. Despite a temporary suspension of direct talks due to a Covid-19 case within an EU team, discussions are expected to continue under health guidelines, and overall sentiment remains confident regarding the eventual finalisation of some form of Brexit deal.
Cautions Signal Potential Underpricing of Risk

Despite the prevailing optimism, some analysts have voiced concerns, pointing to reports that EU leaders might request the European Commission to prepare contingency plans for a no-deal scenario. This suggests a potential divergence between market expectations and the preparedness for an alternative outcome. The pound's slip against a rebounding dollar was also attributed to a general risk aversion in stock markets, driven by rising Covid-19 numbers, which in turn increased demand for the US dollar as a safe-haven asset. At 1634 GMT, sterling was down 0.3 per cent against the dollar at US$1.323 and approximately 0.2 per cent lower against the euro at 89.525 pence per euro.
Potential for Significant Sterling Volatility

The options market and positioning data indicate that a "Brexit risk premium" is not significantly priced into the pound. This implies that the market is largely anticipating a deal, with expectations of an agreement by early next week or the first week of December. Financial strategists predict a substantial downward movement for the pound, potentially between 5 per cent and 10 per cent, should negotiations collapse. Conversely, a finalised deal is expected to result in only a modest upward adjustment for sterling, estimated at 1 per cent to 4 per cent. The current market pricing, therefore, appears to heavily favour the upside scenario, leaving it potentially vulnerable to a sharp correction if a deal is not achieved.

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Are markets underpricing the risk of no Brexit deal?

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