Pound's gain on Brexit transition deal agreement seen capped

London - The pound rallied 1% and gilts slid as Brexit negotiators confirmed a transition deal had been reached, yet the currency’s medium-term gains are likely to be limited, analysts said.

Sterling extended its climb above $1.40 to the highest in a month and UK government bond yields touched a week high, as the European Union’s Michel Barnier said the Brexit talks had reached a “decisive step” and a large part of the final exit treaty had also been settled.

Barnier, speaking at a joint press conference with UK counterpart David Davis ahead of an EU summit this week, said agreement had been reached on citizens’ rights and the exit bill.

That came after a Barclays survey of investors last week found that most respondents didn’t expect an agreement until at least October.

 Despite the gains in Monday’s session, Aberdeen Standard Investments and Rabobank see any pound appreciation as brief, given longer-term challenges faced by Britain, including that of reaching a trade pact with the EU.

“It appears they have made a lot more progress in Brexit talks than many people had thought possible,” said Lee Hardman, an analyst at MUFG. “It increases the likelihood of a smoother and more orderly Brexit, which dampens downside risks for the U.K. economy in the coming years, meaning a stronger pound and more BoE rate hikes.”

The UK currency was up 1.0% to $1.4080 as of 12:30 on Monday, the highest since February 16. It was up 0.8% at 87.47 pence per euro. The yield on 10-year UK government bonds climbed eight basis points to 1.51%.

Stumbling blocks

The biggest stumbling block to a transition deal had been the Irish border, with UK Prime Minister Theresa May saying after the first draft that no UK leader could accept such a deal.

The two sides were not able to reach an agreement on this issue, said Barnier, but both agreed to include a note on how the Irish issue would be dealt with in the draft published on Monday.

The Bank of England’s meeting on Thursday is also in focus, with investors watching for hints that the central bank is ready to raise interest rates as early as May. A hawkish shift in stance by the central bank is largely factored in for sterling.

Money market pricing edged up after the transition deal announcement to give an 84% chance the bank will raise borrowing rates in May, versus just 5% at the start of February.

Higher stakes

As well as the transition deal, the likelihood of a May rate hike is also dependent on U.K. data and the tone of the monetary policy committee’s March announcement, according to John Wraith, head of macro rates strategy in London at UBS.

“We need to see the language, conditions etc., but this is obviously progress and likely enough to cement a May hike in our view,” Wraith said.

“The stakes are going to get rapidly higher so if you’re going to get short-term relief reflected in a stronger sterling, higher short-end rates, a more hawkish MPC, it will prove short-lived,” said Wraith, who sees the pound dropping to $1.37 by year-end.   

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