Pound Sterling Struggles to Recapture Lost Ground against the Euro and U.S. Dollar

- GBP has lost over 1.0% against EUR this week
- Down over 0.5% against USD
- Stock market sentiment remains key
- Brexit talk feedback, EU Council are 2 main obstacles remaining this week

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A softer start to the day for global equity markets means the risk sensitive British Pound has turned lower once more on Thursday and looks on target to record a negative week against the Euro and U.S. Dollar.

The Pound-to-Euro exchange rate is down 1.45% this week at 1.1009, the Pound-to-Dollar exchange rate is down 0.60% since the start of the week at 1.2545.

For Sterling to stage a recovery it will need a series of events to go right: 1) some good news to come out of Brexit negotiations 2) global stock markets to rise further, 3) the ECB and a European Council meeting to disappoint investors and send the Euro lower.

This is a tall ask and, on balance, we would expect Sterling to retain its weak tone as a result.

We have observed the Pound remains highly reactive to falling stock markets, tending to follow them lower as was the case on Monday and Tuesday when a bout of investor nerves saw markets across the world lose value.

Wednesday's recovery helped lift Sterling off the floor but this recovery appears to be absent once more on Thursday, confirming that volatility remains elevated.

Research shows that the Pound is vulnerable against the Euro in particular during times of stock market stresses, tending to follow equity markets lower but only partially recover those losses when they recover.

According to analysis from ING Bank N.V., GBP/EUR is three times more sensitive to falling markets vs rising markets. "GBP suffers proportionally more in falling markets than it benefits in rising markets," says Petr Krpata, a foreign exchange strategist at ING.

In short, this means the recovery in Sterling is likely to be a third of the previous fall meaning falling markets are particularly problematic for the currency. The cumulative fall in GBP/EUR from Monday to Tuesday was 1.48%, however the rebound on Wednesday was a quarter of a percent, suggesting that even a 1/3 recovery potential might be optimistic.

The Pound-to-Euro exchange rate is down a percent this week and finds itself at 1.1033 at the time of writing and the Pound-to-Dollar exchange rate is flat on the week at 1.2603.

Beyond equity markets, the ongoing decline in the yield paid by UK government debt (gilts) is proving a weight for Sterling with observers noting the yield paid by UK government bonds is now less than that of Japan.

"The equity market weakness may have been a contributing factor, but more importantly, the intraday decline in the UK’s 2-year yield below Japan’s equivalent may have added to market concerns about the UK’s ability to fund its rising deficits," says Edward von der Schmidt, a strategist at Morgan Stanley.

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"Over the past decades, the UK’s rising current account deficit has been accompanied by lower gilt yields (following the trend in global yields), causing GBP to weaken to attract foreign inflows," says von der Schmidt. "Now, with the Bank of England engaging in QE to prevent an unwanted rise in yields, UK yields may stay low, suggesting GBP may have to weaken again."

We note that 2-year bond yields have ticked up somewhat over the past 24 hours and would imagine we would require more of the same if Sterling is to be better supported.

Heading into the final part of the week Sterling therefore remains vulnerable against the Euro and we would expect any strength to ultimately remain short-lived in duration until a sizeable shift in fundamentals transpires.

One such potential shift would be an unexpected breakthrough in EU-UK trade negotiations which are due to conclude on either Thursday or Friday, it is never quite clear these days given the talks of the past two weeks ended early.

While the two sides are officially deadlocked there is a chance that some positives could emerge from the latest round of talks, particularly given press reports of late that some common ground for a deal has been identified.

Confirmation of such could put a strong bid under Sterling.

However, with October being touted as the deadline we believe it realistic to expect talks to remain deadlocked for some time yet as it is traditional to reach a breakthrough in the final hours of politically-loaded negotiations, and these trade talks are unlikely to prove any different.

From a Euro perspective, we look towards Friday's meeting of European leaders at the EU Council where the matter of the massive coronacrisis recovery fund will be discussed.

A €750BN fund for EU nations and corporations has been proposed to by the European Commission to help the bloc recovery from the covid-19 crisis, a generous package that has helped the Euro exchange rate complex outperform over recent weeks.

"If successful, it could be a strong elixir for the single currency, as well as providing welcome fiscal policy space for the beleaguered southern economies, especially Italy," says John Velis, FX and Macro Strategist at BNY Mellon.

But owing to opposition by some countries - namely the Netherlands - the fund is unlikely to be approved in its existing state, and this is a key risk to the Euro as a severely watered-down package would likely result in losses.

"Led by Dutch Prime Minister Rutte, the so-called “frugal four” has objections to the size, composition, and governance (conditionality) of the package as proposed," says Velis. "He has characterised his mood going into the summit as somber."

A breakthrough in talks ahead of the weekend could ignite fresh appetite for the Euro, however we expect the issue to be kicked down the road once more and would therefore expect markets to continue giving the single currency the benefit of doubt.