The political questions of Brexit are far from over, despite the U.K. formally leaving the EU on January 1.

The U.K. formally left the European Union on January 1; however, its economic relationship with the EU is far from settled.

Currently, the U.K. and EU are operating within a Free Trade Agreement that allows free trade of goods. Trade of services, which is more important to the U.K., has yet to be decided, with negotiations ongoing.

Regular reviews are built into the agreement, which will center around whether the U.K. has diverged too much from EU regulations to be able to comply with the FTA; for the U.K., the decision will be whether it is achieving sufficient access to the single market to justify regulatory alignment. Politics will play a role here, with many wanting the U.K. to diverge from the EU in order to pursue its own agenda, while others will point to various personal and business disruptions as reasons to stay aligned with the EU to achieve fuller access to the single market.

The balance between aligning with the EU in order to achieve market access and diverging in order to pursue the U.K.’s own agenda will be the key factor in determining what happens with the border in Northern Ireland and the U.K.’s key export to the EU, financial services. U.K. hopes for equivalence might be optimistic given the EU’s aim is to become less reliant on non-EU financial services. EU member countries are unlikely to grant full equivalence in areas other than clearing and allow a “soft” external boarder with the U.K. in Ireland, unless the U.K. makes significant compromises, which would lean against the ideals of Brexit.

Empirical assessments of the economic impact of Brexit are difficult given a lack of a data and large COVID disruptions currently impacting the economy. However, the likely long-term implications will be a less flexible supply side, while the demand side will be both less affected and easier to support through government policy. This dynamic could lead to higher inflation per unit of demand and, therefore, reduced potential real GDP growth. In this outcome, the level and volatility of U.K. nominal yields is likely to be higher for any given level of aggregate demand, while real rates will depend on the public and private sectors’ ability to generate productivity.

For credit markets, the implications are issuer- and industry-specific, as the impacts on business models are far from uniform across the economy. Such variability increases the importance of security selection in credit markets and should provide good investment opportunities.

In currency markets, we believe the outlook for the British pound depends on current account dynamics. Higher nominal yields per unit of demand should mean that the U.K. is able to attract sufficient foreign capital to finance its trade deficit. Increased trade barriers could lead to less “openness” in the economy, reducing the trade balance as a percentage of GDP and therefore causing the British pound to appreciate to restore equilibrium. The magnitude of appreciation will depend on relevant elasticities.