The UK government is set to trigger Article 50 within the next two weeks, formally starting EU exit negotiations. Early exchanges between the two sides will be very important for sentiment and EU negotiators are likely to be cautious ahead of the French Presidential Election.

Relief that the process will start has the potential to lift confidence. Although the impact will be offset by fresh Uncertainty surrounding a potential second Scottish referendum, initial selling is likely to fade and there is scope for a Sterling rally as short positions are reduced. Sterling has scope for a rebound against major currencies with the Euro gaining some support against the dollar.

There will, however, be the potential for fresh Sterling selling later in 2017 if negotiations are seen to be progressing badly.

Phony war draws to a close

The EU Withdrawal Bill has been passed in Parliament as the House of Lords dropped its insistence that amendments should be included. The government now has the mandate to act and Article 50 is, therefore, likely to be triggered late in March, although it could be earlier.

Once Article 50 has been invoked this will formally start the negotiation process and, under the EU constitution, the process needs to be completed within 2 years. Theoretically, if no deal is agreed within the two years, the UK would be forced to leave the EU without any agreement.

The positive aspect is that uncertainty surrounding the start of negotiations will have ended and any easing of uncertainty tends to be a positive short-term factor for currency markets.

EU negotiating tone crucial

EU negotiators have been very unwilling to make substantive comments since the referendum with an insistence that negotiations can only start once Article 50 has been triggered.

The stance of other EU members will certainly be an extremely important factor in the short term. In broad terms, a conciliatory tone would tend to support Sterling while an aggressive, hard-line stance would be more likely to weaken the UK currency.

The situation is complicated by the fact that there are key elections in the Euro-zone this year. The French Presidential election will be held over two rounds on April 23rd and May 7th with the established parties facing a strong challenge from the National Front.

Ahead of the elections, there will be a reluctance to imply that the UK can get a good deal from leaving the EU. Any suggestions of big concessions would risk increasing populist support within France which could increase the risk of a National Front victory.

On the other hand, a notably tough stance towards the UK would risk triggering further criticism of what is seen as the EU elite.  In this context, developments could make little headway. Very slow progress would tend to dampen Sterling confidence. German elections will be held in September or October which will also be an important influence.

UK debate enters a new phase

The triggering of Article 50 will also lead to a shift in UK political momentum with the probability of a much more confrontational tone, especially in view of the Scottish situation.

An extremely important aspect from the UK point of view will be whether there is widespread acceptance that the UK should leave the Single Market and also not be part of a customs union. If there is widespread support for this position, the government will have a potentially much easier task in the negotiations.

If, however, there is still strong support for remaining within the Single Market, there will be major potential divisions and the government will have a much more difficult job.

Scotland uncertainty intensifies

The Scottish National Party (SNP) which controls the Scottish Parliament remains opposed to the UK leaving the EU and is particularly opposed to leaving the Single Market.  First Minister Sturgeon has announced that she will formally call for approval to hold a second Scottish independence vote between Autumn 2018 and Spring 2019.

The UK government will look to resist a referendum on this timeframe which will maintain underlying uncertainty and tend to increase political divisions within Scotland and the UK as a whole.

Concerns over a second vote will tend to unsettle Sterling to some extent even though there is no possibility of a vote within the next 18 months. There will also be concerns surrounding the outlook for Northern Ireland which also voted to stay in the EU in the 2016 referendum.

International trends crucial

International developments will also be very important with a particular focus on US policies. The Trump Administration is pushing for a more aggressive global trade agenda with the threat of protectionist policies amid strong criticism of Japan and China as well as Germany.

If the UK can forge a constructive relationship on the need for global free trade and gather support from other major EU players, this would be important in boosting confidence in the European economy. In these circumstances Sterling and the Euro would likely to benefit.

Bilaterally, positive US rhetoric surrounding any potential free-trade deal with the UK would tend to support Sterling. A positive outlook surrounding trade talks with countries such as China and India would also be extremely important in underpinning Sterling sentiment.

UK economy still the dominant factor

UK economic trends will still tend to be the dominant currency influence. Consumer and investment trends will be important in determining direction for the UK outlook and any impact on Bank of England policy. In this context, the extent to which political uncertainty undermines activity will be a crucial factor.

Investment trends will be extremely important and any high-profile corporate decisions to invest outside the UK or relocate away from the UK would undermine sentiment while evidence of inward investment would boost confidence.

Sterling is already very cheap in valuation terms against the dollar which should underpin capital inflows from the US and Asia.

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