Pound Sterling Looks to Notch up a Third Weekly Advance against Euro and Dollar, but Trade Negotiations Must Offer up Good News

- GBP towards top of recent ranges at start of new week
- Another key week for Brexit trade negotiations lies ahead
- "less than a 3% risk premium is currently built into GBP vs EUR" - ING
- "Brexit risks should limit further appreciation potential" - Commerzbank

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Brexit trade negotiations head to Brussels this week where negotiators must offer up some positive developments if the British Pound is to maintain its recent gains.

The UK currency has rallied through July, in part on the back of hints and reports of the potential for imminent progress in the negotiations which, for now, are said to be deadlocked by officials.

The rumour-vs-reality pull and push on Pound Sterling will likely continue for the foreseeable future and an update on either Thursday or Friday will likely prove to be the Pound's key risk event of the week.

It is difficult to say when exactly talks will conclude, given they had ended earlier than scheduled in the past two weeks. We are still not yet sure what this actually means for the final outcome as negotiations can end early on both deadlock and progress. After all, why sit around if you can see a clear landing zone emerging that can be advanced during negotiation slots scheduled for subsequent weeks?

Nevertheless, there is certainly a high degree of uncertainty and therefore we would remain of the view that rallies in Sterling are likely to remain relatively well contained and that sizeable downside risks remain should sentiment sour.

"Sterling has been able to recover strongly recently on the back of a more positive economic outlook, but Brexit risks should limit further appreciation potential," says Thu Lan Nguyen, FX & EM Analyst at Commerzbank. "There is a high risk that the Pound will suffer much more severe setbacks in the meantime than our forecasts suggest due to rising Brexit risks."

The Pound had ended June looking oversold with markets selling the currency into virtually all market conditions and paying little attention to economic indicators and Bank of England policy. Arguably, neither were supportive anyway, but the Pound had started to trade at levels consistent with 'no deal' certainty.

The Pound-to-Euro exchange rate fell to a low of 1.0890 in late June, the Pound-to-Dollar exchange rate fell to a low of 1.2252 which is consistent with levels reached during extreme 'no deal' fears in 2019.

Above: GBP/USD weekly chart showing 2020 performance

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It is of course still too soon to deploy such negative pricing for Sterling, given that there are still months to go for a deal to be struck, with October looking to be the most credible deadline as this the point by which EU states will require a deal to ratify by the time the year-end deadline to the transition period is reached.

The Pound has subsequently recovered some of those oversold conditions during the course of July, but this week we should see the recovery rally tested as it the market will demand further good news on trade negotiations, something which might not be forthcoming considering we are not yet near the deadline.

"We see EUR/GBP moving towards 0.92 within three months as the lack of anticipated progress in UK-EU trade negotiations should translate into further risk premium being built into the currency," says Petr Krpata, Chief EMEA FX and IR Strategist at ING Bank.

EUR/GBP at 0.92 gives a Pound-to-Euro exchange rate of 1.0870, for reference the 2020 lows was reached during the hight of the coronacrisis sell-off of March when 1.0526 was attained, but the pair had been as low as 1.0890 in June.

"Based on our estimates, and following the recent GBP rebound, less than a 3% risk premium is currently built into GBP vs EUR. We think it's likely that the risk premium will increase above 5% if no meaningful progress in negotiations occurs this summer – which is our base case," says Krpata.

The Pound recorded a second consecutive weekly advance against both the Dollar and Euro last week after the unwind from oversold conditions extended further, aided by further supportive unofficial Brexit trade negotiation reports.

We reported on Friday that a seasoned Brussels journalist reporting that the EU's Michel Barnier is ready to make some significant compromises on behalf of the EU in order to get a trade deal agreed over coming weeks.

Reporting for The Sun newspaper, Nick Gutteridge says Barnier is "ready to water down his red lines - but can only take the plunge if the PM shows willingness to compromise".

This makes for the latest in a series of positive developments concerning Brexit which have allowed the Pound to recover through the course of July: the Pound-to-Euro exchange rate is back up to 1.1168 having started the month at 1.1040 while the Pound-to-Dollar exchange rate is at 1.2612, having started July at 1.2396.

According to Gutteridge, Barnier will offer the UK "a major olive branch by accepting euro judges won't play any role in the trade deal".

Barnier is also ready to soften his stance on fishing and the extent to which the UK will have to match European standards according to the report. However, rumours of compromise on fishing rights have been circulating for days now and were likely responsible for a sharp jump in the value of the Pound late last week when a transcript of Barnier's testimony to a committee in the House of Lords was made available.

These three issues: oversight of EU courts, fishing rights and the following of EU standards are widely held to be the three sticking points to a deal being agreed and signs of movement will likely see the market unwind some of those bets it had built up in anticipation of further Sterling downside.

Reports have emerged over the past ten days that the two sides were close to agreeing 'landing zones' for the outstanding issues, but no official confirmation of such progress has yet been issues which has understandably capped enthusiasm towards the Pound.