This simple prisoner’s dilemma chart from ING explains what Brexit could do to the pound in 2018

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• ING FX Strategist Viraj Patel uses a game theory approach to determine how sterling might move as Brexit progresses.
• Patel’s “Prisoner’s Dilemma” chart provides a handy summation of where the pound may be headed in 2018.
• Sterling dropped in reaction to news that the UK and EU have reached an agreement on the first phase of Brexit negotiations.

LONDON — The UK and EU reached an agreement on Friday on the first phase of Brexit negotiations after overnight talks between Theresa May, European Commission President Jean-Claude Juncker, the DUP and the Irish government.

On the surface, the announcement should have been good news for the pound, creating a little bit more certainty about Brexit talks going forward. In reality the opposite happened, with a small but not insignificant drop in the pound’s value against the euro and the dollar.

No one can be 100% certain of what happens going forward, especially given the wide array of issues still to be sorted once the second phase of negotiations, but it is the time of the year that bank analysts and strategists start making predictions about the next 12 months in the markets.

Among those analysts are the FX team at Dutch lender ING.

In March this year, before Article 50 had even been triggered, ING Strategist Viraj Patel produced a so-called Prisoner’s Dilemma charting the different consequences for sterling that certain developments in Brexit negotiations could have. You can see it here.

Almost 10 months on, ING has released its FX outlook for 2018, and included an updated version of the chart, chronicling how both the pound and euro are likely to fare in the next year.

“Our game theory application to Brexit negotiations is proving a handy framework for analysing the political risks to GBP. While much of 2017 has been marred by UK and EU politicians playing ‘hardball’ with one another, it appears as though the tide may be turning in a constructive direction,” Patel writes.

“Politicians moving away from seeking to protect their own domestic interest (the Prisoner’s Dilemma scenario) – and slowly moving towards a mutual agreement – is unambiguously positive for GBP.”

“For example, while agreeing a ‘divorce bill’ has little economic significance for the price of GBP, the political significance of progress in Brexit talks is quite profound – not least as it reduces the tail risk of a ‘No Deal’ scenario and a complete breakdown in negotiations,” he concluded in the note, published a couple of days before the deal was announced.

Here’s the chart:

ING