U.S. Dollar Draws Support from Pound Sterling's Punishment Beating But Euro Key to Outlook

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- USD supported by punishing losses for GBP, weak SEK.

- GBP erases election gains on return of 'no deal' cliff edge. 

- Losses offset EUR, JPY and CHF gains to tilt USD higher.

- Though U.S. data also aided sentiment toward the USD.

- GBP, EUR price action key to USD index direction ahead.

The Dollar found solace and support in the punishment beating doled out to Pound Sterling Tuesday on reports suggesting Prime Minister Boris Johnson is seeking to create a new 'no deal' Brexit cliff edge, although European currencies could remain in the driving seat of the Dollar index over coming days. 

Prime Minister Boris Johnson will attempt Friday to "legally prohibit" any further delay to the UK's departure from the EU beyond the end of 2020, the anticipated end of the next phase of negotiations as well as the 'transition' period the UK will enter if the withdrawal agreement is ratified. The UK is due to depart the EU on January 31 but Johnson's agreement provides for a year-long period where it effectively remains a member but without representation in EU institutions. 

Johnson will legislate via an amendment to the Withdrawal Agreement Bill this week, according to ITV News, in a move that could mean the UK leaves the EU under a 'no deal' Brexit if negotiators are unable to agree terms of the future relationship before the end of next year. Johnson pledged on the campaign trail to have the EU trade talks wrapped up by the end of next year and subsequently won an 80 seat parliamentary majority in last week's general election. 

"With much of the hard Brexit risk premium temporarily removed from the GBP rate after the election outcome we argue the GBP is in for renewed weakness in 2020. One risk is related to brexit should Mr Johnson and the Conservative government stick to its position on trade negotiations and seriously consider departing by the end of next year, deal or no deal. Moreover, there are several signs that the UK economy is slowing," says Richard Falkenhäll, a strategist at SEB. "This creates a bad mix for the GBP."

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

The Pound had rallied strongly against major rivals in recent weeks as markets saw the increasing prospect of a Conservative Party election victory not only seeing off the threat of an increasingly radical opposition party but also burying the threat of a 'no deal' Brexit for at least the foreseeable future. 

However, that 'no deal' cliff edge was again looming over the British currency Tuesday, leading it to erase all of its post-election gains over the Dollar. So large were Sterling's declines during the European session that the Dollar index was quoted 0.16% higher at 97.17 around the London close. 

Gains accrued to the Dollar Index in spite of the greenback being offered lower relative to all but two of its constituents. The Swedish Krona, which has a 4.2% weighting in the ICE Dollar Index, also ceded ground to the Dollar Tuesday but the Euro, Japanese Yen, Swiss Franc and Canadian Dollar all rose against the U.S. currency. The greenback was higher against risk rivals like the Australian and Kiwi Dollars but those aren't included in the Dollar Index. 

Pound Sterling has an 11.9% weighting in the Dollar index and when combined with the European single currency that has a 57.6% share of the basket, the two currencies account for more than two thirds of flows captured by the index so can have a meaningful impact on its trajectory.

Above: Dollar Index shown at daily intervals.

The Pound had rallied strongly in recent weeks as markets saw the increasing prospect of a Conservative Party election victory not only seeing off the threat of an increasingly radical opposition party but also burying the threat of a 'no deal' Brexit for at least the foreseeable future. However, some analysts were already warning before the ITV report landed that Sterling may have risen as high as it's likely to this side of the trade negotiations and that a correction was in store.

"The broad value of the USD is trading fractionally higher; within the G10 space, the GBP was the most important driver of USD strength. Spot GBPUSD is currently trading down about 1.0% on the day," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

It's not yet clear how much further the Pound can fall in the short-term but one thing that's possible in the wake of an eventual stabilisation is a decline in the Euro, which might itself be enough to offer the Dollar index further support given the single currency's substantial weighting. 

The Euro-to-Dollar rate was pushed higher on Tuesday with no obvious trigger for the gains beyond the move in Pound Sterling, which fell against all of its major rivals including the single currency. Furthermore, the Euro is now close to a resistance threshold around 1.1200 that's previously blocked its path higher on the charts and if it does so again, the resulting declines may offer further support to the Dollar index irrespective of what Pound Sterling does. 

"Further range trading around the 200 day moving average is on the cards today," says Axel Rudolph, a technical analyst at Commerzbank. "Last week EUR/USD briefly rose above the 1.1180 October high and probed the 1.1200 mark. The 55 week moving average at 1.1208 caps for now."

Above: Euro-to-Dollar rate shown at daily intervals.

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