Pound Sterling View: What Happens On a Brexit Breakthrough? 

- GBP leads board as Brexit talks renew, budget update looms.   
- Breakthrough in talks could see Brexit risk premium erased.
- Lifting GBP/USD back above 1.31 & GBP/EUR back to 1.17. 

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The Pound led major currencies in a rebound against the Dollar Tuesday as another round of Brexit trade talks got underway and Chancellor Rishi Sunak's mini budget loomed large, although it could see substantial further gains in response to any progress in the deadlocked negotiations with the EU. 

Pound Sterling rose against all comparable rivals Tuesday as Brexit negotiators headed for dinner at Downing Street to mark the beginning of another round of talks about the future trade relationship, while investors looked ahead to Chancellor Sunak's eagerly awaited fiscal update. 

Sunak's budget will be delivered after Prime Minister's Questions in parliament on Wednesday, where he's expected to announce a package of measures to kick-start the recovery after restaurants and pubs reopened at the weekend following the relaxation of restrictions on other businesses last month.  

The Brexit negotiations will continue through the week and although progress is yet to be officially acknowledged, there have been indications that something might be in the pipeline. Progress toward an agreement could have substantial implications for Sterling because despite Tuesday's gains, it was still lower against half its major rivals for the last month and was the second worst performing major currency of 2020. 

Even if the talks end and deadlock remains in their wake, the downside might be limited until closer to the end of the transition givenSterling has become less sensitive in recent weeks to suggestions from London that it could pursue a trade relationship governed by World Trade Organization (WTO) terms in 2021. 

Above: Pound-to-Euro rate at daily intervals alongside 2-year GB-German bond yield differential (black line).

The Pound has been pummelled since the coronavirus imperilled the national finances and the Brexit trade talks descended immediately into deadlock.

Sterling has lagged others in the race to win back lost ground from the Dollar as result, leading the British currency to underperform all other rivals.

But if the talks were to make progress, placing a trade agreement in sight and ruling out a relationship governed by WTO terms at year-end? 

The last time concerns about a seemingly imminent 'no deal' Brexit were put to bed by a declaration of progress was in October 2019, and led to a four percent rally in the Pound-to-Euro rate that closed the gap between it and the two-year GB-German bond yield differential illustrated in black on the above chart. 

Sterling had diverged from the trajectory followed by the differential between British and German bond yields heading into October 2019, reflecting what analysts call a 'risk premium that had required the Pound to trade at a discount to measures of its perceived fundamental value.

But bond yields, which represent something like the real time borrowing cost of sovereign governments, have been crushed by central banks since March and pinned to the floor using quantitative easing policies as well as guidance that suggests they won't be going anywhere for some time to come. 

Above: Pound-to-Euro rate at daily intervals alongside S&P 500 futures (orange line).

Yield differentials no longer reflect the risk premium or discount that's been steadily imposed on the Pound since May, when investors were forced to confront the lingering prospect of something like a 'no deal' Brexit happening amid the carnage caused by efforts to contain the coronavirus. 

In other words, yields don't say anything about where Sterling might end up as a result of a breakthrough. However, and on the other hand, the level and performance of the S&P 500 index provides a good indication of late.

Many currencies including the Pound have followed it in near lockstep during recent months and to a greater extent than usual, although Sterling hasn't managed to achieve anything like the performance of the benchmark

This has driven a divergence on the charts that has an uncanny resemblance with that seen in relation to the yield differential back in October.

To the extent that this is a risk premium that would be reduced in response to any clear signs of progress in the talks, the upside could be substantial because it points the Pound-to-Euro rate in the direction of 1.17 and the Pound-to-Dollar rate at 1.31, when they traded at 1.12 and 1.25 Tuesday.

Both of the above exchange rates enjoy a positive relationship with the S&P 500 but have lagged it substantially in recent months, though it's GBP/EUR where there is a pressing economic need for a shock absorbing adjustment following a messy Brexit. This is what drives the GBP/USD discount.

Above: Pound-to-Dollar rate at daily intervals alongside S&P 500 futures (orange line).

For the Pound-to-Euro rate to converge with 1.17 on the charts the Pound-to-Dollar rate would also have to close the gap with the S&P 500, otherwise the Euro-to-Dollar rate would need to fall an substantially so because GBP/EUR is a simple reflection of relative price action in GBP/USD and EUR/USD.

The Pound-to-Euro rate could hit 1.17 and the Pound-to-Dollar rate 1.31 at the same time, although they'd require a EUR/USD rate of 1.12 and a great many analysts expect that exchange rate to rise in the weeks and months ahead.

Simple market mechanics dictate that with a rising Euro-to-Dollar rate, Sterling could only reach 1.17 against the single currency if the Pound-to-Dollar rate rose over and above the 1.31 level implied by the S&P 500. As it did back in October in order to facilitate the upward adjustment in GBP/EUR. 

A Pound-to-Dollar rate that rises to 1.31 would have seismic implications for not only the Pound-to-Euro rate, but also for all other Sterling exchange rates and more so the further the British currency rises advances on the greenback. 

Pound Sterling has suffered some of its heaviest losses against the likes of the New Zealand, Australian and Canadian Dollars in the last three months given underperformance by the British currency and outperformance by commodity currencies, but a Brexit breakthrough could turn the tables in a significant way.

Even more so if those commodity Dollars continue to range-trade in the weeks ahead rather than continuing their advance on the U.S. Dollar. However, the best performances might be against the safe-haven Japanese Yen and Swiss Franc given this is where the heaviest post-referendum losses are.

Performances that would be magnified further still if a Brexit breakthrough came alongside a continued global economic recovery that undermined appetite for safe-haven assets and as a result, lifted USD/JPY and USD/CHF.

Above: British Pound performance against major rivals in five years to July 2020.  Source: Pound Sterling Live.