Pound Sterling Dumped as Brexit Tensions Rise

- GBP soft at start of important week for Brexit trade negotiations
- Johnson says UK ready to "move on" if no deal reached by Oct.
- "Autumn ugliness" seen by BMO Capital
- Goldman Sachs sees some GBP upside as 'thin' EU-UK trade deal reached
- GBP "really ignoring the risks" - Nomura

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• GBP/EUR spot: 1.1169 | GBP/USD spot: 1.3227
• GBP/EUR bank rates: 1.0956 | GBP/USD bank rates: 1.2957
• GBP/EUR specialist rates: 1.1060 | GBP/USD specialist rates: 1.3108
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The British Pound starts the new week in subdued fashion as the summer rally against the Euro, Dollar, Australian Dollar and other peers fades ahead of what is being billed as a potentially 'ugly' Autumn for the UK by on analyst.

Perhaps the most important consideration for Sterling on the near-term horizon will be this week's penultimate round of Brexit trade negotiations which are to take place in London amidst subdued sentiment.

"With Brexit talks starting again this week, headlines raising the risks of no agreement between the UK and EU are already putting the pound under pressure," says Robin Wilkin, Cross Asset Strategist at Lloyds Bank.

Prime Minister Boris Johnson has meanwhile on Monday said that if there is no breakthrough by October 15 the UK will accept a 'no deal' scenario and "move on".

According to media reports, Johnson will make clear to the EU that the UK "cannot and will not compromise on the fundamentals of what it means to be an independent country" to get a trade deal as he insists failing to sign a trade deal would be “a good outcome for the UK”.

The developments come as it appears that the two negotiation teams have gone as far as they possibly can under the terms of the briefs provided to them by their leaders, and it will therefore most likely take politicians to break the deadlock.

Indeed, the UK's Chief Negotiator David Frost said at the weekend when laying out the agenda for this week's round of talks:

"From the very beginning we have been clear about what we can accept in these areas, which are fundamental to our status as an independent country. We will negotiate constructively but the EU's stance may, realistically, limit the progress we can make next week."

It appears that time is no longer the constraining factor as the 'red lines' held by the EU and UK appear to have converged around the areas of fishing rights and state aid rules (the so-called level playing field provisions).

"However, the EU still insists we change our positions on state aid and fisheries if there are to be substantive textual discussions on anything else," said Frost.

Also destabilising sentiment towards Sterling on Monday are reports that the UK is set to pass legislation that would ultimately undermine the Withdrawal Agreement, reached between the UK and EU at the end of 2019.

The UK Parliament will soon pass the Internal Market Bill in its efforts to put in place post-Brexit legislation governing the UK's internal market, however some sections of this bill are said to undermine elements of the Withdrawal Agreement that pertain to Northern Ireland.

The clash would potentially mean that in UK courts it is the domestic bill that has precedence over the Withdrawal Agreement which in turn effectively means the UK is undermining an international treaty struck with the EU.

Commentators say the developments would potentially severely undermine the strained trade agreement negotiations, further adding to a view that a 'no deal' outcome is likely.

"The pound is suffering in early trade, following rumours that the UK government could be on the cusp of a move to reverse many of the key promises made to the EU under the Withdrawal Agreement. With the government seemingly planning to implement legislation on Wednesday that would “eliminate the legal force of parts of the … agreement”, does throw a major spanner in the works for Brexit negotiations that had already been strained," says Joshua Mahony, Senior Market Analyst at IG. "Should Johnson seek to go back on those promises made to the EU last October, traders will be very aware that the chances of an all-encompassing trade deal look less and less likely."

Above: The Pound was down against all its major peers on Sept. 07

Foreign exchange markets have turned more cautious on Sterling heading into a period that was always likely to be beset with Brexit tensions and upside potential is only likely to be revived if negotiators reveal unexpected progress this week.

The Pound-to-Euro exchange rate trades at 1.1175 at the start of the week, the Pound-to-Dollar at 1.3223 and the Pound-to-Australian Dollar exchange rate at 1.8155. This is down from respective highs of 1.1280, 1.3480 and 1.8411 reached within the past month.

With Frost openly saying there is limited chance of progress this week we will be on the look out for headlines to come at any time that talks have wrapped up early, given the impasse.

This could provide a knee-jerk downside move in Pound exchange rates.

Last week it was reported Downing Street now sees a 30-40% of a deal being reached, which we noted was likely less than the market was expecting (analysts are currently putting the market's expectation around 60%). Therefore, if the market lowers its expectations over coming days the Pound could shift lower as a result.

Stephen Gallo, European head of FX strategy at BMO Capital Markets says the recent rally in the Pound-Euro exchange rate "should be treated with caution ahead of autumn ugliness."

Any knee-jerk negative reaction to headlines out this week will however likely be short-lived given that the deadlocked state of negotiations have been well signposted to the markets which appear to be of the view that the breakthrough would only ever really come from the politicians.

For this reason October's meeting of EU leaders at the next scheduled European Council summit is being billed as the real make-or-break moment for talks.

Goldman Sachs economists meanwhile expect Brexit negotiations to conclude with a "thin" free trade agreement, including a lengthy implementation phase during which some current EU-UK arrangements are preserved - i.e., in data, aviation and security—and the imposition of significant barriers to trade in services is gradual.

"Under this outcome, Brexit-related risk premium in Sterling should decline, and we forecast that EUR/GBP will edge down to 0.87. But until more clarity emerges from Brexit talks and the health of the domestic economy, we would likely avoid Sterling longs," says Karen Reichgott Fishman, a strategist at Goldman Sachs.

EUR/GBP at 0.87 gives a Pound-to-Euro exchange rate of 1.1388, which is indeed higher than current levels and would suggest some lift on the event that a deal is agreed.

Last week we received an important insight into the state of negotiations via a report by The Spectator's James Forsyth, published in The Times, saying that the reasons for Downing Street's pessimism resides with the issue of state aid, with other outstanding issues such as fisheries likely to be resolved.

Forsyth says the real sticking block to reaching a deal in fact lies with state aid rules whereby the UK government directly supports or stimulates a given industry or company via the provision of direct funds.

Such support won't be in the same vein as traditional industrial support, for example in steel or vehicle manufacturing, rather it will be directed at industries of the future.

In short, technology.

According to the report Johnson and his team want to be able to support UK technology companies to allow them to grow to scale, thereby ending dependence on U.S. and China technologies, which in turn benefit from huge state support.

"The bigger issue is Britain’s desire to use state aid to build up its own technology sector. The view in Downing Street is that this country needs to develop large technology companies at scale and that requires state involvement," says Forsyth.

But for Sterling, it won't just be Brexit headlines that provide intrigue this week as there are two other important issues to consider: 1) the state of the world's stock markets and 2) domestic data.

Global markets have been beset by volatility in 2020 owing to the covid-19 crisis and the substantial flows of money that this volatility has triggered has had significant impacts for Sterling and other currencies.

The rule of thumb is that in times of market confidence the Pound rises, but when markets are pessimistic and stocks are falling, the Pound tends to fall.

Last week's meltdown in technology stocks was met with a decline in Sterling, reminding investors to be vigilant of an important driver of Sterling.

We would therefore look for further downside pressures in the UK currency to emerge if the sell-off continues over coming days. 

On the economic front, Friday's release of GDP data will be of interest as it should provide official confirmation that a strong economic recovery is underway in the UK.

Survey data and various other data have suggested that the UK economy has rebounded strongly following the lifting of lockdown restrictions, a development that could have provided some of the positive impetus seen in Sterling during the July-august period.

However, October sees the ending of the government's job support scheme while the much-lauded Eat out to Help Out subsidy scheme for restaurants and pubs ended in August.

The phasing out of government support is being flagged by economists as one reason to be cautious on the UK economy into year-end, and another reason to be wary of an 'ugly autumn' for the country and its currency.

"GBP is really ignoring the risks. With the furlough scheme ending in October, tax rises on the agenda and Brexit talks not showing the smallest sign of movement it’s been an odd August for price action. We expect September markets to focus on the continued stalemate in trade talks with this week’s Barnier comments showing no signs of a compromise in the short term and a no deal Brexit risk to weigh on the pound in September," says Jordan Rochester, FX Strategist at Nomura.