British Pound Rallies Versus Euro as Brexit Talks Begin, but Benign Outcome to Keep Gains Capped

Pound Sterling rallied at the start of the new week and on a day that finally sees the start of Brexit talks.

The Pound to Dollar exchange rate rose to touch the 1.2800 mark and the Pound to Euro exchange rate touched the 1.1435 level.

Gains come following further signs that the UK Government can't afford not to take a flexible and pragmatic approach to Brexit negotiations that start this Monday. 

Chancellor Philip Hammond told the Andrew Marr show on Sunday that the UK would be leaving both the common market and the customs union as part of its Brexit divorce.

“We’re leaving the EU, and because we’re leaving the EU we will be leaving the single market and, by the way, we’ll be leaving the customs union,” Mr Hammond told the BBC’s Andrew Marr Show.

But, he added the question was not ‘whether’ we would be leaving the EU but what sort of a deal we would be putting in its place.

The Chancellor stressed that a no deal would be a very bad outcome for the UK and that the Government would seek to avoid a cliff-edge when it comes time to exit in 2019.

Talks begin in Brussels this morning and will be followed by a press conference at 17.00 GMT.

The initial focus will probably be on establishing the status of the 3 million EU citizens currently residing in the UK and the 1 million Britons in the EU, said Investec’s Jonathan Pryor in remarks this morning.

“Brussels wants as a priority to guarantee rights for 3 million EU citizens in Britain and be paid tens of billions of Euros it says London will owe on its departure. With a further million British expatriates in the EU, May too wants a deal on citizens' rights, though the two sides are some way apart,” says Pryor.

It is the divorce bill which is likely to be the point of most significant controversy as the EU is insisting Britain pays but such a move would be politically unacceptable in the UK.

If a deal here can be reached relatively quickly we would say this will certainly helps Sterling.

However, don't expect any fireworks too soon.

"Brexit talks start today with key negotiators, Davis and Barnier, expected to hold a press conference later," says Chris turner at ING Bank N.V in London. "This should be a benign event, with both sides committing to a long term relationship and avoiding any detailed reference to the key preliminary issues such as the divorce bill or the status of EU and UK residents in each other’s territory."

ING say they see GBP upside as limited this week, also faced with the Queen’s speech on Wednesday, where the Conservatives will for the first time have to rely on DUP support.

Markets Under-Estimating Political Risks, GBP Particularly Vulnerable v Euro

With Brexit negotiations underway, the Pound is prone finds itself prone to pronounced political risks.

Analysts at UniCredit Bank say they were expecting a more pronounced decline and the resilience by the British Pound against the Euro and Dollar does put their negative view on Sterling view into question.

However, they are sticking to their guns and expect the Pound to decline.

“We believe that the market is currently underpricing political and economic risks and would advise positioning for GBP depreciation, especially against the Euro,” say UniCredit.

Analysts argue that with the formal EU negotiations starting today and investors having already raised their hopes for a soft Brexit, the currency is more likely to find itself prone to negative headlines and downside risk.

UniCredit think the recent developments in UK bond markets are rather difficult to square with political and economic dynamics at home.

Yields on bonds are a key driver of the Pound; when they head higher the Pound follows.

Nominal yields have held up well since the election.

“With the economy heading for a significant squeeze in real incomes, we think it will not be too long before UK real yields resume their descent, putting pressure on sterling, especially against the euro, which remains underpinned by both economic dynamics and political developments,” say UniCreidt.

Euro Vulnerable to Technical Decline

The Euro meanwhile appears susceptible to losses as markets correct following a period of outperformance, which could help Sterling defend itself against Downside.

According to Credit Agricole's FX positioning gauge, the EUR was sold for most of the last week.

"Regardless of last week’s development, speculative long positioning remains close to multi-year highs," says Manuel Oliveri, FX Strategist at Credit Agricole. "Given limited room of rising central bank rate expectations in the short-term, additional position squaring-related downside risk seems high."

To put this another way, the market is engaged in a one-way bet in favour of the Euro.

This makes for a market that is uneven and - importantly - prone to correction as traders exit those pro-Euro bets.