Javid Warning on EU-UK Divergence Prompt Sterling Weakness at Start of New Week

- Sterling in soft start to new week

- Javid warns EU-UK will diverge from current economic alignment

- Sterling likely to remain heavy ahead of Friday's PMI data release

Above: File image of Sajid Javid © Gov.uk, Ministry of Housing, Communities and Local Government

- Spot rates: GBP/EUR: 1.1707, -0.17% | GBP/USD: 1.2993, -0.10%

- Indicative bank rates for transfers: GBP/EUR: 1.1390-1.1480 | GBP/USD: 1.2642-1.2733

- Indicative money transfer specialist rates: GBP/EUR 1.1550-1.1600 | GBP/USD: 1.2800-1.2880 >> Get a quote

The British Pound endures a soft start to the new week, going below 1.30 against the Dollar and trending back towards 1.17 against the Euro, as markets digest latest developments concerning EU-UK trade negotiations and await a key set of economic data due out at the end of the week which will ultimately dictate whether the Bank of England cuts interest rates on January 30.

Weekend comments from Chancellor of the Exchequer Sajid Javid suggest the UK will not seek alignment on EU rules as a basis for their future trade relationships instead the UK would seek the freedom to diverge from EU rules which will in turn allow the country to strike up freshtrade deals with other countries.

"There will not be alignment, we will not be a rule taker, we will not be in the single market and we will not be in the customs union - and we will do this by the end of the year," Javid told the Financial Times, adding, companies must 'adjust' to the new reality.

"GBP is underperforming in markets that are otherwise moderately risk-on overnight. In a weekend interview, Chancellor Javid warned business that that UK regulation would diverge from the EU after Brexit," says Adam Cole, foreign exchange strategist with RBC Capital Markets. "The comments, which would imply limited access to European markets seem to diverge from the 'common high standards' implied by the political declaration on the future relationship."

The Pound-to-Euro exchange rate has fallen 0.17% at the time of writing, taking it to 1.1708, the Pound-to-Dollar exchange rate has meanwhile fallen 0.10% to quote at 1.2993.

The EU wants the UK to stay lock-step with their own regulations in return for a zero tariffs and zero quota trade deal,but Prime Minister Boris Johnson has repeatedly vowed to break free from the EU's rules.

Two weeks ago President of the European Commission Ursula von der Leyen said in a visit to London that while she wanted the EU and UK to be as closely aligned as possible, the more divergence the UK wanted, the less accommodative the future trading relationship will be. By diverging from EU rules the UK will invite more trade barriers from the EU as they seek to protect their own economy from perceived unfair advantages. 

The comments from Javid add to the sense that the upcoming trade negotiations between the two sides will be fraught with difficulty, with the UK wanting to diverge but avoid the costs of doing so. For their part, the EU will likely strike an uncompromising tone on divergence.

This will likely increase market fears that the UK and EU will be unable to secure a new trade deal before the year-end deadline, which will create an atmosphere of anxiety within which the British Pound will likely struggle.

"Brexit uncertainty will continue throughout 2020 if this quote from the Chancellor of the Exchequer, Sajid Javid, is anything to go by: 'There will not be alignment, we will not be a ruletaker, we will not be in the single market and we will not be in the customs union.' Who’d trade Sterling?" says Daniel Been, a strategist with ANZ Bank.

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Sterling Faces Key Data Test this Week

Anticipation of tough trade negotiations come as technical studies of the headline GBP/USD and key GBP/EUR exchange rates both suggest Sterling will struggle over coming days, but the release of PMI data for January at the end of the week will likely prove a pivotal moment for the Pound's outlook.

Members of the Bank of England Monetary Policy Committee have this month stated they will be looking for a strong pickup in economic activity in January in order to justify keeping interest rates unchanged at 0.75%; any suggestion that the economy remains sluggish would almost certainly see them cut interest rates on January 30. The rule of thumb in currency markets is that when a central bank cuts interest rates, or signals it intends to do so, the currency it issues falls in value. This dynamic has been a feature of Sterling markets for the duration of January.

Therefore, a rate cut at month-end will likely bake in current levels in Sterling which are well below the highs seen in December.

"What will it take for the MPC to cut rates this January? Not much. Market pricing for a January rate cut has shifted notably over the last few weeks to just above 70%. To put this in context, when we changed our call for a rate cut in early December, markets were barely pricing anything (~10%)," says Sanjay Raja, Economist at Deutsche Bank. "The MPC have started to get more risk averse. Uncertainty around the Bank's forecasts have risen. Yes, the Conservative's decisive victory last month lifted some political uncertainty, but the Brexit saga has only just begun."

The flash PMI for January, out on January 24, will give markets their first substantive insight into the performance of the economy in the post election period.

The Manufacturing PMI is seen rising from 47.5 to 48.8 but remaining below the 50 level that separates industry expansion from contraction. Meanwhile the more important Services PMI is seen rising from 50.0 to 51.1 this month.

Should the data come in below expectation the Pound will likely extend its recent bout of weakness as that interest rate cut becomes assured. However it will take a decisive beat of expectations for markets to believe the Bank will row back on their threat to cut interest rates, under such a scenario we would imagine the Pound to end the week on a strong note.

“A stream of disappointing UK data has confirmed the MPC's concerns and sharply increased the odds of a January rate cut. Both November UK labour data and January PMIs will be crucial factors to watch next week. A downside surprise or signs that the data is not improving would likely cement market expectations of a cut,” says Chris Turner, head of FX strategy at ING.

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