British Pound Weakness "Should not be Underestimated as Brexit Reality Sinks in"

• Pound to Euro exchange rate: 1.1136, down 1.95% in a month
• Pound to Dollar exchange rate: 1.2996, up 2.2% in a month

1. "There is little reason to doubt that the pound will continue to underperform in the G10 FX space"
2. But now Cabinet is apparently united in their desire to see a transitional period on Brexit will help alleviate some concerns.
3. Politics weighs on US Dollar complex
4. Euro strong in after-glow of ECB meeting

ING Bank N.V warn those with an interest in Pound Sterling's future direction that they should not expect an easy ride for the UK currency over coming weeks.

Analyst Viraj Patel at ING Bank’s London branch (pictured above) briefs clients that, “GBP's weakness should not be underestimated in the current $-selling backdrop.”

What he is suggesting is that the rise in GBP/USD above 1.30 might be flattering the Pound as that decline is largely a function of Dollar weakness and not Sterling strength.

Indeed, the Pound is wallowing at fresh eight-month lows against the Euro as we speak, largely thanks to a fresh bout of Euro strength following the ECB’s July policy meeting.

There are a number of reasons to believe Sterling is likely to struggle.

“The stagflation warning signs are flashing for the UK economy after this week’s data, while any ‘soft’ Brexit euphoria is slowly beginning to fade as the reality of difficult negotiations begins to sink in,” says Patel.

On July 21, markets were briefed by chief negotiators David Davis and Michel Barnier after a week of technical discussions, and the message was that little progress had been made on the initial targets - sorting out the future rights of EU and UK citizens, the Irish border and the financial settlement.

“This is now likely to be the theme for GBP markets over the coming months and in this environment, there is little reason to doubt that the pound will continue to underperform in the G10 FX space,” argues Patel.

Patel says that while GBP/USD sub-1.30 seems about right, EUR/GBP looks set for a near-term test of the psychologically important 0.90 level.

“Risks are that we stay above there,” says the analyst.

EUR/GBP at 0.90 equals a Pound to Euro exchange rate at 1.11.

As we note here, there are a range of views concerning the GBP/EUR's outlook, with one major analyst suggesting 1.0 is likely.

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Gove Hints at a Brexit Transitional Period

Michael Gove (C) Policy Exchange.

For Patel, the future performance of Sterling is therefore linked to the severity of the Brexit anticipated by markets and the actual road to Brexit.

The process is arguably as important as the final outcome, and on this front, the latest news is actually positive.

Michael Gove - the UK’s fresh Environment Secretary - has given a firm hint that the UK will be seeking a long transition period in which to implement Brexit.

The transition period would cove the first two years after the UK’s exit from the European Union in March 2019 and would look to keep the existing relationship with Europe intact.

Gove told an audience in Woking, Surrey that the Cabinet was united over the issue of an EU transition deal.

This suggests the free-flow of workers between the UK and Europe - a key condition of maintaining single-market membership.

The news will be welcomed by UK businesses seeking clarity on the issue and should allow them to make investment decisions now that they know a cliff-edge awaits them on March 2019.

It also suggests that a unified position at the top of Government might finally be forming which should make the process smoother.

Gove was speaking in Woking at a conference organised by WWF-UK where he laid out plans for the UK’s future environmental and agricultural strategy.

Gove also delivered a robust criticism of the decision by the United States to exit the Paris Agreement on climate change.

Pound Sterling has been struggling of late with the issue of Brexit starting to weigh on sentiment once more.

Now that negotiations with the EU have commenced in earnest markets have turned attention to the issue once more having been distracted by the General Election and global events over recent months.

That Cabinet is now apparently united in their desire to see a transitional period on Brexit will help alleviate some concerns.

Dollar Struggles on Political Uncertainty

It's not just Sterling that is beholden to political machinations.

The US Dollar is weak and the Dollar index - a measure of the USD based on its strength against key partners - is pushing to fresh lows on the back of renewed political uncertainty out of Washington.

"The theme appears to be escalating in the aftermath of Thursday’s Mueller headlines as market participants assess the implications for the administration’s growth agenda and the outlook for the Fed," notes Eric Theoret, a strategist with Scotiabank.

Special counsel Mueller, who is in charge of the Russiagate probe, apparently intends to extend the investigation to other branches of Trump’s activity, including the business transactions of his companies.

There is a sense amongst traders that Trump's problems mean his promised tax cuts and spending increases are now further away than ever.

Euro Strength

The European Central Bank tried hard to keep a lid on rising yields and a rising Euro in their July policy update. 

The yield on Eurozone-based debt (bonds) has been rising since his speech in Sintra, Portugal after ECB noted in a speech that the Eurozone was reflating and Draghi used his appearance in Frankfurt on July 20 to try and warn markets against expecting any major shift in policy over coming months.

A rising cost of borrowing is exactly what the ECB is trying to avoid and explains why Draghi emphasised that a September taper announcement looks increasingly unlikely as the ECB said that a “very substantial degree of accommodation is needed” to boost inflation.

Such communication in the past would have sent the cost of Eurozone borrowing sharply lower, taking the Euro down too.

But not this time as the Euro jumped higher following Draghi's warnings, so what’s going on?

It appears that markets just don’t believe the ECB and its President, largely because the Eurozone economy is firing quite nicely and inflation is on an upward path.

"While the central bank head said measures of underlying inflation remain low, he also indicated that core inflation will rise over the medium term as stimulus pass through supports demand and favourable financing conditions help investment," notes Kathy Lien, Director of BK Asset Management.

The ECB stressed that their quantitative easing programme will run until the inflation rate picks up but with core inflation starting to rise the market can clearly see what is on the horizon.

"There's no stopping the euro now that European Central Bank President Mario Draghi made it clear that his concerns for low inflation are limited," says Lien.

In short, markets can see through Draghi’s attempts to artificially quash yields and the Euro.

“We would not be very afraid of a dovish Draghi today. Near-term, the Euro will be the most sensitive to any pushback on the recent tightening in financial conditions and in particular the strength of the exchange rate. But even if this happens we would buy EUR/USD on any dips: simply put, the ECB may not have much choice but to accept a stronger Euro,” says George Sarvelos at Deutsche Bank in London.

Saravelos has argued for a few weeks now that the ECB will not be able to stop market forces - the economy is growing and it demands a stronger currency.

City Index’s Kathleen Brooks notes that there was not enough new substance to convince traders they need to now bet against the Euro's upward trend:

“This meeting’s message is very similar to the last one, and no news means no change in trend. Draghi’s tolerance of the stronger Euro is also helping the single currency.”

So it’s full steam ahead for the single currency it would appear.

Of late we have noted a number of analysts upgrade their forecasts for the Euro with HSBC saying they see EUR/USD striking 1.20 by the end of 2017 and EUR/GBP racing towards parity.

If HSBC are right, this will put a massive strain on those who import from Europe, so I would suggest you get cracking with securing your hedges.

We do note a good amount of year-end forecasts for EUR/GBP do however reside in the 1.11 area where strong support lies and for now we would not be panicked by the 1.0 forecast, yet.

Viraj Patel at ING Bank N.V says that while GBP/USD sub-1.30 seems about right, EUR/GBP looks set for a near-term test of the psychologically important 0.90 level.

“Risks are that we stay above there,” says the analyst.

EUR/GBP at 0.90 equals a Pound to Euro exchange rate at 1.11.

One way or another the answer in this whole equation rests with whether or not the ECB does announce a taper of its asset purchases in September and the key to this outcome will be upcoming inflation releases.