22 November 2018

Why the bankers won’t bail out May’s Brexit deal


As things stand, Theresa May’s Brexit deal seems very unlikely to pass. Though there is some evidence that the public has become a bit more supportive since its strongly negative initial reaction, the Withdrawal Agreement does not currently have anywhere near the votes needed to pass the House of Commons.

One theory, which was originally attributed to Rupert Harrison of BlackRock but which has since taken on a life of its own, is that financial markets might react so negatively to Parliament voting against a deal, that MPs would feel compelled to pass it (or something substantially similar) at the second time of asking.

The precedent for such a turn of events is the US House of Representatives first rejecting and then passing legislation to create the Troubled Asset Relief Program (TARP) in 2008. TARP was conceived as a way to get distressed assets off bank balance sheets, to unblock money and credit markets in the aftermath of the Lehman Brothers bankruptcy.

As someone who was a rates trader at the time (and on a trading floor the night of the TARP vote), my two main feelings are relief that I no longer have to follow every single twist and turn of this saga in real time, but also frustration at some of the misconceptions about how markets work.

There are some outward similarities between the two situations, but also some important differences. But before I get into them, it’s helpful to define a concept that has been raised by others in relation to how markets might react – that of “pricing in”.

The price of a financial asset can be interpreted as what the market is willing to pay today for a set of promised or expected cashflows in the future. That means, in theory, that current valuations should reflect all available information that might change market participants’ expectations of future cashflows, or their view of what they are worth today. If expectations – and in turn prices – do reflect a particular view or piece of information, then the latter is said to be priced in.

I can think of four main differences between TARP and the current situation. First, in 2008, traders mostly thought that TARP would probably pass, while knowing that, because of this expectation, equity markets would sell off heavily in the event that it didn’t. Knowing what’s priced in ahead of time usually isn’t clear cut, and traders can’t be expected to be on top of everything at all times.

But it’s safe to say that if almost every pundit in the traditional media and social media thinks that there is little chance of the Commons passing the bill at the first attempt, then this is not something that has escaped traders’ attention, and their expectations will be set accordingly.

Secondly, with TARP, traders didn’t immediately assume that there would be another bite at the cherry. It started to be talked about almost as soon as the extent of the selloff became clear, but crucially, if this had been the expectation all along, the sell-off might not have happened to the same extent. With Brexit, while it’s known that a failure of the deal at its first attempt could lead to a disorderly exit, the expectation (whether correct or not) is that something could still be done – “no” isn’t automatically “no deal”.

Third is the urgency. The risks in 2008 were immediate and the cost of delay was seen as substantial. Liquidity was drying up, and systemic risks (the risk that banks can’t repay their debts to other banks, who in turn then can’t repay their own debts, and so on) were rising by the day, as was the perceived likelihood of broader economic damage.

We can, of course, debate how different the effect would have been if TARP had been passed first time, or not passed at all, just like we can debate the economic consequences of different flavours of Brexit, but it’s the perception (and the levels of risk aversion) on the day that count, not what actually happens in the real world months later. Delaying the Brexit deal legislation by a few weeks may have some economic (and therefore market) impact, but it’s not as immediate as banks potentially running out of money.

Finally, because Americans have traditionally been prolific retail investors, selloffs hit voters directly in the pocket, because their savings are worth less. It’s not hard to see how that changes the political dynamics. That’s not the case to anything like the same extent in the UK, where savings are likelier to end up either in cash ISAs or in bricks and mortar, neither of which are marked to market in real time. A crash in the value of the pound would create an inflation risk via import prices, but in most cases not immediately.

So while we can’t and shouldn’t rule out a market move of some sort after the vote, there isn’t guaranteed to be one, especially if it isn’t automatically seen as leading to a “no deal” Brexit. And if there is a selloff it might not be big, and even if it is big, it might not be enough to move politicians.

Circumstances that might be expected to move markets would include the bill failing by a wider-than-expected margin, or if there is reason to think that it may trigger other market moving events (such as resignations, no-confidence votes, and so on) or if the likelihood of a no-deal is reassessed for some other reason. Whatever happens, it’s far from clear that markets would be able to turn politicians around in a few days.

Matt Singh is the founder of Number Cruncher Analytics.