Pound Sinks Against Euro and Dollar as Past Performance Weighs in Thin Pre-holiday Trade

The British currency's outperformance during November, political uncertainty and imminent tax-reforms in the US are both factors helping to constrain the Pound Tuesday.

The Pound sank against the Euro, Dollar and much of the G10 basket Tuesday as the currency gave back more of the gains it racked up earlier this month, when markets were betting a deal to move Brexit negotiations forward would lift the currency into year-end.

Tuesday’s fall in the Pound-to-Euro rate was disproportionate to that seen elsewhere across other Sterling pairs. Driving this move is the combination of a sharp spike in the Euro-to-Dollar rate and a slide in the Pound-to-Dollar price, both of which took place in thin pre-holiday trade.

Sterling was quoted 0.23% lower at 1.3346 against the Dollar while the Pound-to-Euro rate was marked 0.49% lower at 1.1292 around the London close Tuesday. The Euro-to-Dollar rate was marked 0.28% higher at 1.1819.

Markets can set Pound-to-Euro prices independently of other rates but, as a foreign exchange cross-rate, GBP/EUR is at heart the product of a simple equation that divides GBP/USD over the EUR/USD price.

These are the underlying mechanics of the market and so, when the prices set by independent order books deviate away from the output of the above equation, any discrepancy is quickly arbitraged away.

“The weakness of the pound, which is currently the worst performing G10 currency versus the US dollar on a month-to-date basis, is likely to be an anomaly. A quick transition deal still appears the most likely outcome in Q1 2018, a scenario which has yet to be factored into the price of the pound,” says Derek Halpenny, European head of global markets research at MUFG.

Above: Pound-to-Euro rate shown at hourly intervals.

With cross-rate phenomena aside, Tuesday’s feebleness may also be a symptom of looming tax reforms in the US and the Pound's strong rally throughout November, which was in anticipation of an agreement to move Brexit negotiations onto the subjects of trade and transition.

That agreement was forthcoming on Friday. However, European Council guidelines to negotiators in the second phase of talks, also released Friday, have now created scope for a new bout of “deadlock” once into the New Year. 

British and European negotiators have said repeatedly that “nothing is agreed until everything is agreed”, referring to the agreements struck over the “financial settlement”, the Northern Irish border and citizens rights.

Prime Minister Theresa May has also said that there will only be a transition period, and a financial settlement for the EU, if it is clear in March 2019 what future relationship the UK will be transitioning to.

However, the European Council’s guidelines make clear that some amount of trade discussions will have to be left until after the UK’s scheduled departure date on March 29.

“Look for higher EUR/GBP in early 2018. The Euro has been weighed down by the widening EUR/USD cross currency basis into year-end but the latter should narrow again after the New Year,” says Guy Stear, head of emerging markets strategy at Societe Generale. “Moreover, a EU-UK trade agreement is not yet a done deal and Euro area growth momentum still outshines the UK.”

Quie apart from new uncertainty for markets, this creates scope for renewed difference between London and Brussels to emerge, potentially leading to another round of deadlock.

Given the so called “divorce bill” is not recognised by the UK government as a legal liability, but more an ex-gratia payment designed to smooth the path to a trade agreement, UK negotiators might be reluctant to pay the bill without having received anything in return.

The guidelines, in theory, would allow EU negotiators to draw trade talks out over a “clearly defined and precisely limited in time” transition period, during which British money will fill the European budgetary hole created by the UK’s departure, only to leave Theresa May alone at the altar at the end of that period.

But all is not lost for Sterling as Friday's agreement on Brexit talks came against a backdrop of Prime Minister Theresa May’s government having suffered a major defeat in the House of Commons.

This saw MPs given the power to halt the UK’s departure from the EU and to send Theresa May back to the negotiating table if they do not like the deal that is struck.

“Recent developments in the Brexit negotiations continue to support our view that the UK is ultimately headed for a softer Brexit. This is likely to provide ever more support to our constructive view on sterling which we have expressed through higher GBP/CHF,” says Kamal Sharma, a strategist at Bank of America Merrill Lynch.

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