GBP/EUR Exchange Rate Rally Could Stall at 1.2048

The British Pound has reacted positively to the news the UK is heading to the polls on June 8.

The knee-jerk market response has seen GBP and gilt yields move higher on the assumption that the new election will lead to a much larger Conservative majority, which is traditionally considered to be a positive for UK markets.

Markets seem to be anticipating the chance of a ‘softer Brexit’ coming out of the election and most scenarios suggest this.  

We noted much talk of a greater majority for Theresa May allowing her to break away from the harder wing of her party that is intent on pursuing a hard Brexit.

If May were to lose and form a coalition, then this would also result in a softer Brexit.

"Even though the political uncertainty has increased, currency markets seemed to take the view that the Brexit would unlikely be much ‘harder’ given the early elections," says Georgette Boele at ABN AMRO Bank in Amsterdam.

Boele believes financial markets may also even judge that there is now a minor probability for a Bremain.

The snap elections generate some short-term noise, but it is believed the consolidation of power in Britain could offer a clearer mandate in the Brexit negotiations.

“Given today’s breaks through some key technical levels, GBP will be one to watch over the coming days and weeks, with the currency likely to start trading more closely with election polls,” says James Rossiter, an analyst with TD Securities in London.

The market also has the ability to run higher as more bets against Sterling are closed out.

“As speculative investors have been excessively short for a while, this Sterling recovery has probably triggered the closing of some of these excessive speculative Sterling short positions,” says Boele who believes the current bout of strength has the ability to extend.

The view that Sterling is engaged in a technical short-covering rally that sees short positions closed has been expressed by others.

"Today’s news has been a good enough reason for another squeeze in short GBP positions – in our opinion the most credible explanation for GBP’s post-announcement rally,” says Viraj Patel at ING Bank N.V in London.

Boele believes a test and break of the 1.2775 in GBP/USD (December high) is likely in the near-term.

If these speculative excessive sterling shorts are squeezed further, GBP/USD could easily reach and break 1.30 in the coming weeks.

“Meanwhile, EUR/GBP is on its way to reach, test and break below 0.83 as the uncertainty of the French Presidential elections weigh on the Euro says Boele.

EUR/GBP at 0.83 equates to 1.2048 in GBP/EUR terms.

TD Securities say their high-frequency fair value model argues a significant discount for GBP and the model points to a break below 0.83.

This is a break above 1.2048 in GBP/EUR terms - a number that mirrors that presented by ABN AMRO.

Meanwhile, the French election remains a key risk for EURGBP, and analysts continue to favour downside momentum in the Euro through the event.

However, should a mainstream candidate win then we should expect some strength in the Euro.

Game-Changer for the Pound

Deutsche Bank's George Saravelos has suggested the recent shift in the UK political landscape represents something of a “game changer” for the Pound.

Recall that Deutsche Bank have long been bearish on Sterling and have forecast the EUR/GBP exchange rate will fall to parity.

Deutsche Bank have long argued that the Pound is exposed to notable downside thanks to the complexity of the Brexit negotiations ahead and at some point the markets must price in the ‘hardest of Brexits’ i.e the UK defaulting to World Trade Organisation tariffs.

They argue that this would most likely be avoided, but the journey to the actual agreement will be fraught with risks for Sterling.

However, the election and potential majority it presents gives May more room to negotiate and organise a slower, more orderly Brexit.

"It makes the deadline to deliver a `clean' Brexit without a lengthy transitional arrangement by 2019 far less pressing and second, it will dilute the influence of MPs pushing for hard Brexit," says Saravelos in a note dated April 18.

"We have been structurally bearish on sterling for the last two years but are now changing view. We are closing out all our bearish FX trades,” says Saravelos.

French Elections a Key Near-Term Driver for the Euro

Most analysts are maintaining the base case scenario that sees Emmanuel Macron win the French presidency.

Such an outcome would likely see some degree of strength in the Euro as risks associated with a Le Pen and Melenchon victory are taken out of the currency.

However, analysts at ABN AMRO believe a victory of Fillon would probably be the best-case scenario for financial markets, as his plans are the most ambitious with regard to stimulating economic growth and also the most beneficial for government finances.

Given the recent polls of the first and second round of voting, a victory for Macron is more likely.

“We think that in regard to economic reforms and consolidating government finances his plans are also favourable, albeit less ambitious than Fillon’s,” says ABN Amro’s Boele.

In the event of a Macron victory, ABN AMRO expect the 10-year French spread to fall back to around 50 basis points and EUR/USD to rise to 1.10.

The Euro will also therefore likely recapture ground lost against the Pound.

“If Le Pen or Mélenchon would win, we expect a significantly less market friendly outcome; the Euro would drop sharply and we expect much higher government spreads of 225 and 125bp, respectively,” says Boele.

Rossiter says a decent turnout for Le Pen in the first round this weekend (voting share > 30%) would be a near-term catalyst for further downside in EUR/GBP.