Recovery Back Above 1.20 for GBP/USD, More Weakness Likely

After falling below the key 1.20 level on Sunday, GBP/USD has since staged a comeback, rising to a high of 1.2065.

The was partly driven by comments from Donald Trump in an interview with The Times newspaper where he said that the UK was at the top of a list for a trade deal with the US, and that the UK did a great thing by leaving the EU.

Other factors that have soothed the Pound this morning include some reassurances from the UK Treasury that it will address investors concerns that may arise from Theresa May’s speech on Tuesday.

This “recovery” is also typical after a move below a key technical level such as 1.20 in GBP/USD, and thus may only be temporary.

Signs still point to further GBP weakness

Looking ahead, we think that the pound is likely to remain vulnerable, and, in the short term, the market could once again test the air below 1.20, and the lows from October’s flash crash.

Volatility levels in GBP/USD, as measured by the options market, have risen once again on Monday, taking the 1-month GBP/USD volatility level to a fresh 4-month high. This suggests that investors are expecting further large moves from the pound in the short term.

Why is the pound still so sensitive to Brexit?

Some have wondered why the FX market continues to be “shocked” by news about a hard Brexit, after all the UK’s exit from the single market has always been on the cards and is not a new concept.

I would argue that the ‘Brexit theme as bad news for the pound’ is such an ingrained trend at this stage that it really doesn't matter what May says or fails to say on Tuesday.

Instead, it’s all about market dynamics, and right now the balance of market participants are shorting the pound. It's a bit like a tipping point, once a trend gets critical mass, like the GBP downtrend, then news headlines can have big impacts, as they generate another wave of selling.

Could May’s speech on Tuesday actually help GBP?

Tuesday’s speech in London on Tuesday could trigger a “material drop” in the value of the pound, according to one of the PM’s aides, but is the PM calling the market’s bluff?

There is an outside chance that May’s speech, if it includes details on what will replace single market access, could actually benefit the pound next week, for three reasons.

Firstly, key Brexiteer, David Davies, has said that it is likely the government will push for a transitional deal to ensure that access to our European trade partners is not stymied during Brexit negotiations.

Secondly, the weekend papers also featured comments from the European Union’s lead negotiator who voiced concern about shutting the UK’s financial system out of Europe because of the disruption this could cause to financial markets. Lastly, the City’s lobby group dropped its request for financial “passporting” rights at the end of last week, which suggests to us that they may believe that a better option is available down the line.

Thus, Sunday’s breach of 1.20 could be a classic sell the rumour, buy the fact. However, Theresa May will need to give the speech of her life to reverse the wave of negative sentiment towards the pound right now.

Brexit certainty could prove to be the pound’s tonic

It will be an uphill battle for Theresa May to trigger a sustained pound rally this week, especially since Brexit has been a green light to sell sterling. Added to this, markets are once more reducing their long positions in sterling. According to the most recent CFTC data, net long positions in GBP/USD fell to -65.8k last week, vs. -64.7k the week prior.

But, and it’s a big but, if she can deliver a level of candidness we have not come to expect from the UK government, this may be enough to slow GBP selling if she can deliver some level of certainty about what Brexit will look like and how the government will cushion any blow from leaving the single market.

GBP/USD on the precipice ahead of May’s speech

Late on Sunday, the market was not favouring the pound, suggesting that May’s foscus on immigration in favour of single market access has been viewed badly by the FX market. GBP/USD was flirting with the psychologically important 1.20 level, which could herald a move back to 1.1841 – the low from October’s flash crash (according to Bloomberg pricing).

If Theresa May can’t instil market confidence on Tuesday then the second wave of GBP selling could trigger a move back towards 1.10 in GBP/USD, we would also expect heavy losses in GBP/JPY, and the pound’s recent recovery against the euro is also likely to reverse.

FTSE 100 a silver lining to pound weakness

Conversely, this could be good news for the FTSE 100, which has, so far, been immune to the bad news surrounding Brexit. and reached another record high on Friday. Even the FTSE 250 - which is a stronger reflection of the UK’s economy than the FTSE 100 – was also higher on Friday.

This index has generally been tracking the FTSE 100 since December, suggesting that Brexit fears are not clouding investors’ view of the corporate Britain, at least not yet, anyway. We could see further FTSE 100 upside on Monday now that GBP/USD is below 1.20

Elsewhere, on the agenda..

This week we’ll mostly be talking about Burberry results on Wednesday, the ECB meeting on Thursday and, of course, Trump’s inauguration on Friday. May’s speech on Tuesday and her meetings with Chinese officials at Davos this week are also high on our agenda, as they could potentially move UK markets. But as the pound takes a dip at the start of this week, we believe Theresa May has a tough job to convince markets that she can manage a “clean and hard” Brexit, without doing long-term damage to the UK economy.