Sterling has been under particular pressure since the Bank of England warned last week that the economy could be sinking into a stagflationary quagmire.

It appears that the UK government is actively considering ripping up parts of the hated Northern Ireland protocol agreed with the EU as part of the Brexit deal. The protocol effectively created a customs border between Great Britain and Northern Ireland down the Irish Sea; something that the UK government never really wanted to accept in its negotiations with the EU and now it is trying to revoke by arguing that it excessively complicates and damages trade with Northern Ireland. In addition, elections in Northern Ireland last week saw the prior Democratic Unionist Party (DUP) government ousted in favour of the former political wing of the IRA – Sinn Fein.

However, both parties are required to set up a devolved administration in Northern Ireland and the DUP is refusing to do so until the protocol issue with the EU is sorted. The UK government argues that this hastens the need for a deal on the protocol to be agreed with the EU and this has turned into yet more threats that the protocol could be ripped up because months and months of talks over the protocol have made virtually no progress. Former Brexit Secretary Lord Frost constantly threatened the EU that the UK would unilaterally ditch the protocol, but never went through with it.

A concern now for some is that his successor, who is also Foreign Secretary, Liz Truss, is more willing to carry out this threat, not least because she is eyeing up PM Johnson’s job should he be ousted by the infamous ‘Partygate’ scandal surrounding ‘illegal’ parties in Number 10 Downing Street during Covid lockdowns.

Why does all this imperil the pound? It does so because the EU would almost certainly respond to any action the UK takes to remove the customs barrier that runs along the Irish Sea. Should this escalate to tariffs and essentially a trade war it is clear that there would be only one winner in the market’s eyes – and it would not be the UK. Already, estimates suggest that imports from the EU have fallen by up to a quarter – relative to non-EU imports – since Brexit trading conditions came into effect at the start of 2021. And this, in turn clearly seems to have added to the surge in UK inflationary pressure, particularly in food, because this collapse in imports has not reflected a slump in demand. Should the Foreign Secretary spark a trade war with the EU as early as next week by unilaterally revoking some parts of the protocol, the market would undoubtedly fear more inflation, more cost of living pressure and much weaker growth than even the -0.25% that the BoE forecast for the UK next year just last week.

Unsurprisingly, it is said that others in the Cabinet, notably Chancellor Sunak are very sceptical of taking such a brazen path. We too are concerned but suspect, as maybe Sunak does, that this might be more of a threat than action at this stage as the government tries to prise concessions out of the EU over the protocol. The problem, though, is that such pressure, which the UK has applied before, does not seem to be getting the results the UK government wants and we are sceptical it will be any different this time.

And, in the end, the UK may row back, not least because reneging on the protocol risks infuriating others that the government wants to forge trade deals with in the future; not least the US. So, the bottom line is that we are not unduly concerned that the UK government will spark a possible trade war with the EU next week. This being said, we feel it is best to take a defensive view of the pound, at least against the dollar, not just because we might be surprised by the Foreign Secretary’s decision next week, but also because the macroeconomic fundamentals of the UK look poor even without a trade war with the EU.