British Pound Rally "Grows Long in the Tooth" but Euro and Dollar Constrained by Political Flashpoints

• Market rate at the close of the week:
• Pound-to-Euro exchange rate: 1 GBP = 1.1337 EUR
• Pound-to-Dollar exchange rate: 1 GBP = 1.3860 USD

Pound Sterling's good run could be due a pause but the Euro and Dollar could yet be undermined by political challenges in Berlin and Washington in the near-term.

Pound Sterling ended higher against most of its major competitors on week-on-week basis on January 19 when markets closed.

The gains could have been better had profit-taking on the rally not taken some of the shine off what has been a stellar week for the currency.

FX Strategist Ned Rumpeltin at TD Securities in London tells clients he believes the Pound's rally now "looks a bit long in the tooth. Some near-term caution is warranted."

Sterling pared gains on its impressive run towards the key 1.40 level against the Dollar with markets likely to increasingly increase their offers of the UK currency ahead of this big figure.

The supply of Sterling will likely impact moves in other crosses, hence we would expect the Pound-to-Euro exchange rate to also suffer some selling pressures.

"Some caution on GBP," says Rumpeltin in a client note. "A weaker-than- expected read on retail sales helped to suck the wind out of GBP’s sails."

Nevertheless, TD Securities hold GBP in their Model FX portfolio as one of their 2018 year-ahead trades; indeed it has been one of the best performers vs the USD on a YTD basis, aided by signs of a softer Brexit.

"Price action suggests that the rally looks a bit tired and we think it may be prudent for short-term players to pare back some risk as cable runs into thick resistance into the 1.38/1.40 area. The 1.3660/1.3720 looks to be credible support for now," says Rumpletin.

Sterling went off the boil following the release of softer-than-forecast retail sales data out mid-morning certainly failed to aid Sterling's cause with the Office for National Statistics releasing data which showed UK retail spending fell by 1.5% during December, a steeper reduction than the 0.8% decline expected by economists, while fourth-quarter growth came in at a measly 0.4%.

Economists had predicted retail sales would grow by 0.8% for the final three months of the year, which would have been in line with the expansion seen in the third quarter.

The impact on Sterling of the headlines was ultimately muted however.

"A disappointing set of retail sales figures out of the UK has done little to dent the ascendancy of the Pound, amid a week of upside for sterling. However, today’s figures should be taken with a pinch of salt, with the deterioration in December retail sales coming amid a shift in shopping trends, towards the black Friday/cyber Monday fuelled November rather than last minute pre-Christmas spending in December," says Joshua Mahony at IG.

Indeed, the impact to Sterling was by no means sizeable and what we are in fact seeing is Sterling caught in a wedge between moves in the Euro and Dollar which are the dominant drivers on global FX markets at present.

And, ahead of the weekend a number of analysts are warning politics will be a key driver of foreign exchange market trade.

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Euro and Dollar Face Potential Pitfalls

"There are two big deadlines looming - a potential U.S. government shutdown if a funding bill is not passed by Friday and a vote by the Social Democrats in Germany to begin talks with Angela Merkel on a grand coalition this weekend," says Kathy Lien, Director at BK Asset Management in New York.

Lien says as a result of concerns surrounding the two events both the US Dollar and Euro could come under selling pressure as investors take profits or cut their long positions ahead of these key event risks.

Concerning politics in Washington, it is noted that were members of Congress fail to a reach a deal or the SPD votes against a coalition, the Dollar and Euro will fall sharply.

"A shut down would be bad for sentiment and depending on how long it lasts would potentially hurt US business and consumer confidence and thereby growth. This would in turn further weaken the USD against the EUR, JPY, CHF and GBP," says Manuel Oliveri, FX Strategist with Crédit Agricole.

The US Dollar sold off across the board on Thursday, January 18 on the back of McConnell's warning to plan for a shutdown, with some eleventh hour scrambling, "we still believe the GOP will secure enough votes to keep the government running and if we're right, it should lead to a Dollar recovery," says Lien.

But there will only be a bounce if they reach a deal because right now traders are betting this to be unlikely.

Concerning the Euro, much depends on whether the SPD vote at a party conference on whether or not they go into coalition with Angela Merkel's party in Germany.

There has been resistance to the move with the Berlin chapter this week saying they would not back a deal, but leaders of the Social Democratic Party believe they will secure enough votes to win approval to move forward with a coalition deal.

However, should this prove incorrect we could see some political risk premium absorbed by the single-currency in the near future which could allow the Pound-to-Euro exchange rate to edge higher.

"We feel that Germany’s political risk remains somewhat under-appreciated in current environment and highlight Sunday’s SPD vote as a potential source of turbulence," says Shaun Osborne, an analyst with Scotiabank.

Striking a more optimistic stance are the team at UniCredit who have for a good while now been unashamed Euro-bulls:

"Although uncertainties loom large, we continue to expect the party to give its approval. Whether there will be the formation of a grand coalition in the end crucially depends on the precise coalition treaty and the SPD membership vote on it, which will take place after the formal coalition negotiations, probably in the second half of February or at the beginning of March. A rejection by the SPD on Sunday would lead to snap elections, as the conservatives have ruled out the formation of a minority government," says a note on the matter from UniCredit.

We agree and believe German politics ultimately represent a benign risk to the Euro - rather it will be the European Central Bank who meet next week who pose the real challenge for the single currency.

Policy-makers have during the course of the past week expressed unease about the strengthening Euro and there are suspicions that the currency could grab a mention next week.

At worst the ECB will delay tapering their asset purchase programme in response to the rising Euro in order to try and calm market expectations.

Ultimately though the Euro is going higher as the Eurozone economy puts in a strong period of growth, betting against the Euro longer-term is therefore unwise.

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