The Pound Recovers vs. Euro: 'Dead Cat Bounce' or End of the Sell-off?

Above: Prime Minister Boris Johnson and Secretary of State for Northern Ireland, Julian Smith during Johnson's visit to Northern Ireland. Image (C) Number 10 Downing Street.

- Sterling recovers off multi-month lows

- Analysts say sell-off had become overdone

- But, any strength expected to be short-lived and shallow

Pound Sterling has recovered some ground against the Euro and other major currencies over the course of the past 24 hours, and the question we are asking is whether this strength is sustainable.

The Pound-to-Euro exchange rate has recovered back to 1.0976 which places it at the bottom of a long-term range: it could be that this level now provides technical resistance to the recovery and acts as a barrier to any sustainable advancement. However, a sustainable move back into the range could introduce us back to familiar territory and prompt a period of consolidation.

The Pound-to-Dollar exchange rate is meanwhile trading at 1.2130 and looks to be under sustained pressure, largely owing to the Federal Reserve event overnight that saw policy makers cut interest rates, but fail to convince markets that further numerous rate cuts lay on the horizon. This has triggered a broad-based rally in the U.S. currency.

Indeed, from the GBP/USD perspective, much could rest on what the Dollar decides to do over coming days.

Nevertheless, we have been hearing over the course of the past 48 hours that the aggressive sell-off in the Pound witnessed at the start of the week was due a pause.

"Uncertainty will probably persist. However, after the recent sharp sell-off, the pace of the decline of UK currency might slow," says Mathias Van der Jeugt, an analyst with KBC Markets in Brussels.

The Pound slumped to fresh two-year lows against the Euro and Dollar amidst signs that the new administration of Boris Johnson was determined to deliver Brexit by October 31, even if this meant leaving the EU without a deal.

Johnson has laid down a new red line in the process: the Irish backstop clause must be removed from the existing Brexit deal as a bare minimum. The EU have a long-standing red line that the backstop stays, suggesting to foreign exchange traders that the two sides are simply too far apart, and too stubborn, to arrive at a negotiated exit.

"GBP has been under selling pressure driven by political risk factors. 'Noise' levels in the headlines are high," says Hans Redeker, a foreign exchange strategist at Morgan Stanley. "The Irish backstop remains the sticking point and it may need a concession from the EU on this point to provide lasting GBP support."

"We continue to favour expressing GBP weakness via CHF and EUR," adds Redeker.

Despite Johnson's apparently hardline approach to Brexit, he does maintain that the chance of a 'no deal' is "vanishingly small".

This optimism flies in the face of market nerves, but does serve as a reminder that many in the market might be caught wrong-footed on any positive developments in the Brexit saga.

Van der Jeugt says investors might start to look for small hints from both sides (EU and/or UK) that could lead to an official contact in one way or another. Even so, there is no reason to fight the sterling negative trend yet.

"Brexit has a long way to run before it reaches a conclusion. So, in our view, in the near-term Sterling is oversold and in our FX strategy we are overweight the British Pound versus the U.S. Dollar," says Mark Haefele, chief investment officer at UBS Global Wealth Management.

"What could turn the doomsday narrative around?" asks Jordan Rochester, a foreign exchange strategist for Nomura. "We need to see the EU provide Boris something new to work with."

Rochester says an addition potentially supportive development for Sterling would be the UK Parliament makes "some noises", however this is "difficult to do on recess."

A shift in stance by Johnson could also trigger a recovery in Sterling.

Johnson could "tack more towards the centre ground in the debate before this weakness finds a positive political catalyst to materially offset it," says Rochester.

Antony Maule at Deutsche Bank says Sterling is likely to see some "short-term profit taking," but, the currency should ultimately remain "under pressure as the market shifts expectations for 31st October; a no-deal Brexit slowly cementing itself as the base case scenario."

"Price action this week would suggest the size and speed of the GBP selloff has caught the market off-guard, leaving fast participants underinvested in the downside. I suspect price action and liquidity to be more sporadic than usual near term. We remains core short GBP in the inventory, but have lightened exposure for now," says Maule.

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