This Short-Squeeze on the GBP/EUR Exchange Rate Finally Runs into Trouble

Has the recent run of good fortune experienced by the British Pound been nothing more than a technical short-squeeze higher?

There are suggestions that the UK currency has benefited from the technical repositioning on global foreign exchange markets, and not the fundamental readjustment that would fill those hoping for a stronger currency with confidence.

In short, the sustainability of the March-April rally is being brought into question.

The suggestion comes as Sterling is seen trading well off its March’s high against the Euro which were seen at €1.1784. 

At the time of writing the exchange rate has faded back to €1.1662.

There was some data behind the move with the UK manufacturing PMI release for March declining from February’s 54.5 to 54.2. The consensus expected a modest rebound to 55.00.

“The report didn’t change the overall picture on the UK in a profound way. Even so, it help to block the recent short-covering rally of Sterling,” says Piet Lammens at KBC Markets in Brussels.

What is a Short-Covering Rally?

A short-covering rally - or a short-squeeze - is a situation in which a heavily-sold currency moves sharply higher, forcing traders holding positions against that currency to close out these positions which in turn adds to the move.

A snowball effect ensues that runs counter to the popular trend.

A short position is a bet against a currency, in this case Sterling and the suggestion is what we are seeing is a bunch of traders jumping out of a market that has momentarily turned against them.

There is no major shift in sentiment for the better which would usually be depended on to drive a sustained rally and the trend is ultimately likely to reassert.

“The jury is still out, but today’s price action suggests that last week’s Sterling short-squeeze maybe ran its course. Will political tensions and/or softer eco data again become more important as a driver for Sterling trading?” asks Lammens.

Pound's Strength Labelled an Aberration

Backing up the suggestion that strength in the Pound is likely to be merely technical in nature is Nick Verdi, Senior FX Strategist at Standard Chartered bank in London.

In fact, in a recent note to clients Verdi describes Sterling’s recent strength as an “aberration”.

“The UK-specific risks of Brexit negotiations suggest that short squeezes in GBP will prove to be aberrations on a downward trajectory,” says Verdi in a note to clients.

Standard Chartered have they remain bearish on Sterling on a multi-month timeframe noting that higher-than-expected UK CPI inflation and an incrementally less dovish Bank of England in the context of stretched short GBP positioning have driven the move.

i.e. the move higher is technical in nature - the market is in a one-way directional bet that can be prone to violent and sudden reversals as some participants are periodically thrown out or opt to take profit.

“While we remain bearish on GBP-USD, upside surprises to UK economic data or encouraging noises on the UK’s Brexit negotiations with the EU could drive an outsized and violent short squeeze,” says Verdi.

Such moves can be triggered by better-than-expected data releases, for instance we are seeing Sterling rally nicely following the release of UK retail sales data for February.

For Standard Chartered, even the positive data pulse of March (inflation and better-than-expected retail sales) are not enough to remove the uncertainties posed by upcoming Brexit negotiations.

“We expect these drivers to be more than offset by the negative economic fall-out from UK-EU Brexit negotiations,” says Verdi.

The Outlook? Pound Showing Sideways Potential say KBC

So if the short-squeeze is slowing, where could the rate go next?

KBC Markets have changed their short-term bias on EUR/GBP from positive to neutral.

Last week’s decline of the euro reinforced the EUR/GBP downside momentum and further consolidation in the medium-term sideways range might be on the cards.

"The decline below the 0.8592 previous break-up suggests that a full retracement to the 0.8402 range bottom is possible," says Lammens.

From a GBP into EUR perspective this suggests the move above 1.1638 could extend to 1.19.

"However, the pair shows tentative signs of a shor-term bottoming out process," says Lammens hinting the Pound might not be able to push to much further.

"Longer term, Brexit-complications remain a potential negative for Sterling. We are not convinced that the BoE will raise rates anytime soon, even not after recent higher inflation data," says Lammens.