The Pound Remains Under Pressure Against Euro as Deutsche Bank Concerns Simmer

The British Pound (GBP) remains under pressure as global investor sentiment sours over renewed concerns about the risks posed to financial markets by Deutsche Bank and the Italian banking sector.

At the time of writing the Pound to Euro exchange rate (GBP/EUR) is at 1.1669 and the Euro to Pound sterling conversion is at 0.8569.

The Pound is presently seen as a risky asset since the UK voted to leave the European Union; it will therefore only benefit when markets are in a positive frame of mind.

Therefore when markets are in the red, expect the Pound to suffer, even if the selling is a result of problems in the Eurozone.

Why? When European investors are nervous they tend to repatriate their global investments, this naturally creates a huge demand for the Euro.

The European banking sector is under the spotlight once more with concerns of an escalating crisis in Italy continuing to simmer.

The worry is over EUR360bln of nonperforming loans in Italian banks - the size of the loans are large relative to the size of the Italian economy and the size of bank balance sheets.

"There is a political dimension to this problem which has the potential to impact markets globally, coming into force if PM Renzi loses his Senate referendum in October, not only creating a political vacuum should PM Renzi resign, but also increasing the probability that Italy installs an EMU-critical government aiming to take Italy out of the currency union," says Hans Redeker at Morgan Stanley.

The temperature has however been turned up by Italian Prime Minister Matteo Renzi who has pointed a finger at a bigger potential source of financial instability than Italy’s banks - Deutsche Bank.

Deutsche Bank’s share price hit a record low on Thursday and the Euro Stoxx 600 Banking index is at lowest since the height of the Eurozone sovereign debt crisis in 2012.

Deutsche’s 5-year CDS has risen to its highest since November 2011, "the clearest symbol of how much investors are worried about the bank," says Wilson.

The IMF says Germany's largest bank is the riskiest globally systemic bank, and it’s one of just two major banks that recently failed the Federal Reserve's stress tests.

It is therefore arguably more dangerous to the global financial system than the entire Italian banking sector.

Deutsche’s derivative’s exposure is staggering and it is this that Renzi is seeking to highlight.

"If the market did go against Deutsche the implications for Europe’s – and the world’s – financial system would be enormous. Deutsche could be the next Lehmans," says Neil Wilson, Markets Analyst at ETX Capital.

According to eFinancialCareers, who has quoted one ex-Deutsche Managing Director:

“People are panicking in a serious way. I’ve taken at least two dozen calls in the past week from former colleagues asking my thoughts and advice. – They’re worried about legal issues, Brexit issues and business model issues.

"The feeling is that Deutsche hasn’t evolved like its peers – at least J.P. Morgan has a massive commercial bank and Morgan Stanley and Goldman Sachs have amazing equities and advisory franchises. Deutsche has none of that; it’s got a very large fixed income business and it’s sat in Europe."

Turning back to the EUR/GBP exchange rate again - we must remember - that it is likely the Pound that is at risk here.

"For EUR to weaken, long-term capital outflows must exceed commercial EUR buying needs generated by the Eurozone's ever-rising current account surplus," says Morgan Stanley's Redeker.

Weak balance sheets combined with low nominal bond yields and falling global inflation expectations take currencies within the current account surplus environment higher, and country's with a current account deficit (Britain) lower.

Beware the Short Squeeze Higher

Much of the strength we saw earlier on Thursday may be put down to being nothing other than a short-covering rally.

The market is so one dimensional in its desire to sell GBP that it risks the prospect of an aggressive countermove.

This is often referred to as a ‘short squeeze’ - everyone is betting one way, and any reversal triggers a number of automatic stop losses.

These stop losses are set by traders as protection should the market move against their trade; it protects them against losses by closing their trade.

They therefore create demand for Sterling, which then triggers more stop losses, which in turn trigger even more stop losses.

This cascade effect is therefore technical in nature and not indicative of a turn-in-trend.

In order for us to suggest a bottom has been found we would look for several days in which the pound closes at a higher level than at which it closed.

Until then, we would expect the market is merely going to look to sell the British Pound on strength.

“In an environment, in which central bank rate expectations remain strongly capped and in which political uncertainty persists, sentiment is likely to remain in favour of selling GBP rallies,” says a strategy note from Credit Agricole.

Fellow French investment bank BNP Paribas meanwhile say they continue to see risks as lying to the downside for the pound and they believe the next catalyst for a GBP sell-off could come from the Bank of England when they deliver their next policy decision next week.

Overnight index swaps are currently implying the following probabilities for an interest rate cut:

• 78% chance of a cut next week
• 86% chance of a cut by August, with a 27% chance rates will be 0% by then
• 89% chance of a cut by December, with a 34% chance rates will be 0% and an 8% chance rates will be negative by then

So one interest rate cut is priced into GBP for 2016, therefore the downside risks lie with that second cut.

The other unknown is the extent of any expansion to the Bank of England’s quantitative easing programme.

“In our view the market is still likely under-pricing BoE easing, with our economists forecasting a 25bp rate cut next week followed by a 25bp cut at the August meeting and GBP 100bn worth of QE (including corporate bonds) to be announced by the November meeting,” say BNP Paribas in a briefing to clients.

Meanwhile, TD Securities have updated clients with their latest forecast on GBP/USD.

"The implications of the UK’s Brexit vote begin to sink in, we see protracted downside risks for sterling. We expect GBPUSD to trade down to 1.20 by the end of this year. The risks to our forecast are currently skewed to a further—and faster—decline," says analyst Ned Rumpeltin.

TD Securities think 1.3205/10 is likely to contain any near-term rebound.

Looking beyond the 1.2798 post-vote low, analysts see several items of technical interest clustering in the 1.2515/60 zone; below this, the next major are of support comes into play around 1.1880.