"We Suspect the British Pound Will Continue to Rally Against the USD and EUR"

Pound Sterling was seen sharply lower against the Dollar, Euro and other G10 majors just hours before the UK enters an historic transitional phase with the European Union.

The UK currency fell as traders opted to book profits on a recent rally in Sterling which suggests they are wary of any potential volatility in the currency over coming days.

On Wednesday, March 28 the UK will activate Article 50 of the Lisbon treaty and commence its exit from the European Union.

Once the exit clause is enacted, there is no way back and the UK and EU will begin what is likely to be a strenuous two years of negotiations.

The immediate question for us is “how will the British Pound react”?

The debate continues to be the most lively one in foreign exchange circles at present with big-hitters such as Barclays arguing a rally is likely while the likes of Deutsche Bank argue the opposite.

But these big institutions are more interested in the longer-term period covering the next few months and quarters.

What of the Pound’s near-term performance though - can the recent strong run continue over the coming days that cover the Article 50 trigger itself?  

“Outside of a natural GBP risk aversion pullback, we suspect that the GBP will continue to rally against the USD and EUR,” says Peter Rosenstreich, head of market strategy at Swissquote Bank, based in Gland, Switzerland.

Above: The daily chart for the Pound to Euro exchange rate reveals Sterling to be grinding out a short-term recovery.

Rosenstreich believes the massive GBP devaluation on the Brexit vote and shortest G10 position in IMM data will protect Sterling from a deeper correction.

IMM provides the best insight into how big traders are positioned on the market and gives us a view of what the most popular bets are at the present. In short, it shows us what the structure of the market looks like which in turn gives us some good clues on potential direction.

Because the market is so one-sided in its bet against the British Pound that finding the requisite new market entrants to push the price ever-lower is becoming increasingly hard to do.

This observation on positioning is shared elsewhere and the only way is up, some might say.

We have heard from Credit Agricole that Sterling is their top pick in the G10 space for a short-term rally owing, in part, to the heavy positioning story.

Credit Agricole’s strategic trade model this week indicates foreign exchange traders should buy the GBP, NZD and CHF while selling the USD, CAD and AUD.

Betting on More Gains

The Pound to Dollar exchange rate trades at 1.2549 at the time of writing, having started the week at 1.2485. In fact, if Sterling can advance on the Dollar this week then we will have observed three successive weeks of gains.

Above: The weekly chart shows the GBP/USD exchange rate rising in a constrained channel. Can it eke out a little more upside to the top of the range?

"Although our fundamental view on Sterling remains bearish, we would highlight the risk of further tactical upside correction in GBP-USD, as speculative shorts widened further last week from already extremely stretched levels,” say analysts at UniCredit, the Italian banking giant.

Meanwhile, Swissquote’s Rosenstreich argues ongoing resilience in UK economic data and surprisingly hawkish MPC minutes will have markets increasingly pricing in a Bank of England interest rate hike over coming months.

“The unexpectedly hawkish tone will provide a solid backstop for selling and initiate a rebound in GBP,” says Rosenstreich.

Swissquote anticipated the ongoing GBP/USD recovery off 1.2110 support should continue and they are targeting a move higher to the 200 day moving average on the charts at 1.2755.

Ipek Ozkardeskaya at London Capital Group has also noted the important 200 day moving average observing the GBP/USD retraced from 1.2615, after having traded above its 200-day moving average for the first time since June 23rd Brexit vote.

"The trend is positive above the distant 1.2420 (major 38.2% retracement on two-week rise). There is a minor support at 1.2495 (minor 23.6% retracement). Only a break below 1.2420 level would suggest a bearish reversal," says Ozkardeskaya.

Volatility is a Guarantee

But not everyone is convinced Sterling's run higher has legs and believe the pickup in rhetoric concerning Brexit negotiations following the trigger of Article 50 could be damaging to the currency.

At the very least, some volatility should be anticipated.

"We think the market may have moved on too quickly because no one knows how strict the E.U. response will be we need to respect the price action and the fundamental drivers behind the move," says Kathy Lien, Director of BK Asset Management in New York. 

With this in mind Lien and her team continue to believe GBP will fall after Article 50 is triggered.

"But shortly thereafter, the reality that an exit won't be finalised until late 2018 will set in.  So in the near term, rallies in GBP/USD between 1.26 and 1.27 should be sold," says Lien.

With the uncertain impact of triggering article 50 on Wednesday, March 28 and the potential volatility this implies, any gains enjoyed by the pound lately could be mitigated by the immediate impact of this historic development.

“For now the Pound and Euro remain finely balanced, but sterling’s pre-Article 50 bullishness is likely to be short-lived," says David Lamb at FEXCO International Payments. “With Brexit uncertainty set to dominate Sterling’s relationship with the Euro for months to come, Wednesday’s events merely mark the end of the beginning.”