Pound-Dollar Rate is Seen Heading Lower as Technicals and Politics Favour the Downside

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- GBP set for declines against USD says Commerzbank technical analyst.

- As Capital Economics looks for weakness on Johnson leadership victory.

- Losses would snowball in the event Johnson goes for a 'no deal' Brexit.

The Pound was treading water against the Dollar on Thursday after stabilising in the previous session but it faces a testing few weeks that analysts at Commerzbank and Capital Economics say are likely see the British currency succumb to fresh weakness. 

Sterling was beaten back from a six-week high Tuesday by a Dollar that had caught a moment of respite from relentless speculation that significant Federal Reserve interest rate cuts are on the way, only for the exchange rate to stabilise during the Wednesday session. 

However, technical analysts at Commerzbank watching the charts say that current levels are unlikely to last for long because the decline on Tuesday amounted to a "key day reversal" that could signal a change of trend that favours the downside. 

"GBP/USD continues to struggle at the 1.2763/72 resistance (the 7 th June high and February low) and charted a key day reversal on Tuesday. The Elliott wave count has turned negative implying that the market has failed here and is likely to slide back to the 1.2667/00 region and the 1.2559/1.2506 recent lows," says Karen Jones, head of technical analysis at the German lender.

Above: Commerzbank chart of Pound-to-Dollar rate showing technical indicators.

The Pound was trading at 1.2698 Thursday but Jones says it would have to rise and close above 1.2784 in order to void the bearish signal given off by the charts on Tuesday and to attract a renewed bid from the market. 

"The market will have to overcome this weeks high at 1.2784 on a closing basis in order to generate some further upside interest. This will target the 200 day moving-average at 1.2921, but we are looking for this to then cap the topside," Jones says, in a note to clients Thursday. "Below 1.2506 would target the 1.2444 December 2018 low. This is the last defence for 1.2108, the 78.6% retracement of the move up from 2016."

Jones and the Commerzbank team have closed their earlier bet that the Pound-to-Dollar rate would go on rising and are now recommending to clients that they bet against the British currency from current levels. 

Their reasons for going 'short' on the Pound are entirely technical in nature, so based upon studies of trends, momentum and other signals coming from the charts, but there are also fundamental reasons for expecting Sterling to decline over the coming weeks and months. Some of them were outlined Thursday by Capital Economics. 

"Short positions against the pound have started to build up again. This helps to explain why it has failed to make much headway against the dollar this month," says Hubert de Barochez at Capital Economics. "Dollar/sterling continues to be primarily driven by developments on the Brexit front, rather than by relative rate expectations."

Above: GBP/USD rate at daily intervals, with UK-U.S. bond yield differential (orange line, left axis).

The Pound, trading just below the 1.27 handle on Thursday, has fallen from above the 1.31 threshold at the beginning of last month after Prime Minister Theresa May announced her resignation. Her pending departure has paved the way for a leadership election that looks likely to put a Brexit-backing Boris Johnson in 10 Downing Street.

Johnson has told colleagues and party members he intends to attempt to negotiate changes to the EU withdrawal agreement brought back from Brussels by Prime Minister Theresa May, with a view to having the so-called Northern Irish backstop stripped out of it.

He claims he'll take the UK out of the EU whatever the weather on October 31. In other words, if the EU doesn't agree to the changes he's pushing for, then a 'no deal' Brexit could then become his default stance. Economists and analysts say that would highly damaging for Pound Sterling. 

"If Mr Johnson does become Prime Minister, it is likely that the pound would weaken a bit," Barochez says. "However, that wouldn’t make “no deal” the only possible outcome. This is because Mr Johnson’s aim is to restart negotiations with the EU, and Parliament might still be able to prevent a no-deal Brexit. So only if the UK were to leave without a deal would we expect dollar/sterling to fall, to 1.15 by end-2019 from 1.27 now."

Above: GBP/USD at weekly intervals. Shows disconnect from UK-U.S. 2-year bond yield differential.

"Despite the narrowing in the gap between 2-year government bond yields in the US and the UK to around 100bps, which would normally put upward pressure on sterling in relation to the dollar, the pound has come under renewed pressure falling to $1.27," says Paul Dales, chief UK economist at Capital Economics, in another note to clients.

It's uncertainty about the UK's likely path out of the European Union, and mounting fears the nation will leave without having signed the withdrawal agreement made by Theresa May with Brussels, that explains why Pound Sterling has not followed the differential between UK and U.S. short-term bond yields higher in recent weeks.  

Financial markets are betting heavily the Federal Reserve will cut its interest rate from a post-crisis high of 2.5% to 2% or below before year-end, and a number of Federal Reserve policymakers have to some extent, validated this view through a series of communications including the dot-plot of forecasts published last Wednesday.

These bets have seen the U.S. two-year bond yield fall from 2.1% at the end of May to 1.78% by the end of June, which has narrowed the negative differential between UK and U.S. yields from -1.4% to -1% in what should have been an advantageous development for the Pound-to-Dollar rate, which normally follows that differential. 

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower interest rates or yield differentials normally seeing investors driven out of and deterred away from a currency. 

Capital Economics says the Pound will weaken further if Boris Johnson is elected Prime Minister next month and that it will fall substantially if a ''no deal' Brexit takes place on October 31, when the current extension of the Article 50 negotiating window expires. The result of the leadership election will be announced on Monday 22, July.

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