Pound at Risk VS Euro, Dollar as Bears Return Warning “Sufficient Progress” is Just the Beginning

A Brexit "breakthrough" related rally to higher levels has not materialised for the Pound and Sterling bears are now beginning to re-emerge from the woods.

The Pound-to-Euro and Dollar rates are vulnerable to renewed falls, say strategists, who have warned that Prime Minister Theresa May’s claim of victory in the Brexit negotiations may be premature.

A recent agreement on the avoidance of physical infrastructure at the Northern Irish border, the protection of EU citizens rights after Brexit and the “divorce bill” clears the way for talks to progress onto the subjects of trade and transition to a new model after December’s European Council summit.

However, moving talks along is merely the first of a series of hurdles facing UK negotiators, so disagreements and deadlocks could easily return to haunt the Pound in 2018. Only then, the March 2019 scheduled departure date for the UK to leave the European Union will have drawn closer.

“Although the end result of the past two weeks of drama around the EU-UK divorce bill has ended up with a reported break-through in the negotiations, we note this is but one of many hurdles in the overall Brexit negotiation process, which will increasingly dominate GBP in 2018 as we head closer to the cliff-date of March 2019,” says John Normand, head of cross-asset strategy at JPMorgan.

Sterling rose by 2% against the Euro and Dollar during November, as initial reports of a deal to move talks along emerged and then turned to reality in early November.

Many have suggested in recent days the passing of the “sufficient progress” hurdle will clear the way for the Pound to reach new highs against its rivals toward year-end.

“Depending on how the negotiation process evolves, GBP/USD risk scenarios range from 1.26 to 1.47, and rather than a directional conviction in spot, our favored GBP trade is to be long EUR/GBP volatility,” says Normand.

Normand recommended JPMorgan clients use options, which are complex financial instruments, in order to benefit from wild swings he anticipates will continue to define the Pound-to-Euro rate in 2018. JPMorgan forecasts the Pound-to-Dollar rate will still trade around the 1.3400 level at the end of 2018, and that the Pound-to-Euro rate will fall to 1.0894 by the end of that year.

“It was the breakthrough UK Prime Minister May needed so badly, but looking at the details, the deal contains some serious political stumbling blocks. Markets took the deal with reservation, as shown by only minor appreciation of the pound sterling to levels around EUR/GBP 0.87,” says David A. Meier, an economist at Swiss wealth manager, Julius Baer.

European negotiators had previously insisted “sufficient progress” be made across the three areas of citizens rights, the Northern Irish border and the so called financial settlement before talks can move onto trade and transition.

“While the worst downside risk, a no deal at all scenario, could be removed, the parties will move on to the second but more difficult part of the negotiations, namely a trade deal,” says Meier.

Since Prime Minister Theresa May returned from Brussels Friday claiming victory and that the European Council will vote to allow talks to progress, the reaction from the market has been underwhelming.

“The exit deal will not lead to sustained pound relief, as we continue to expect the UK to lose its EU single market passport. Hence, we maintain our long-term bearish view on the pound with a 12-month target of EUR/GBP 0.92,” Meier adds.

Much of the concern around UK’s departure from the EU comes from expectations banks will lose their financial services passports, which enable them to operate across the EU without multiple licenses.

“Even if an initial agreement looks feasible, the process remains extremely difficult and lengthy – not least to the internal political disruptions inside the UK government,” says Antje Praefcke, an analyst at Commerzbank. “Enough time also has to be left for the decided agreement to be ratified by the individual member states.”

While to be expected, the passporting loss is concerning to many because the financial services industry is the UK’s largest employer and the dominant industry in London. Many firms may have to move a portion of their operations and people over to the continent whatever the weather after Brexit.

“For now, EUR-GBP therefore remains the plaything of the Brexit negotiations. The pound will have hardly a chance versus the USD, though, as it will become clear towards year-end that the Fed will probably raise rates more aggressively than the market currently expects. This argues for lower levels in GBP-USD,” says Praefcke.

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