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Sterling risk skewed to the upside, as Brexit talks move to next phase

Sterling risk skewed to the upside, as Brexit talks move to next phase

The pound's performance in 2018 was unsurprisingly on the weak side, largely due to a stronger US dollar but also owing to the fractious state of politics throughout that year. Looking ahead, as we did a year ago, the outlook for 2019 could only be described as murky at best.

Throughout the year we had to contend with consistent calls for parity against both the euro and US dollar, and while plausible scenarios to a point, none of them were really grounded in reality. As explained consistently over the years, even when allowing for the politics to intrude, currency moves are rarely a zero sum game.

For a start a move to parity would need one of two things to happen, first of which would have been a no-deal Brexit on 29 March 2019. For all the political noise this was never going to be allowed to happen. It is true that such an event would have significant consequences for the UK, but equally it would also have had catastrophic consequences for the EU, and Ireland in particular.

A global slowdown set against trade tensions between the US and China has hammered Europe and in particular Germany extremely hard, while the car industry has slowed sharply this year. Given that the UK, China and the US make up the bulk of Germany’s exports, the political claim that the EU was prepared for a no deal Brexit was exposed for the empty threat that it was. A fact that has been borne out by three Brexit extensions, with the latest one extended to 31 January 2020.

This was why, even a year ago the vulnerable side for sterling has always been a move to the upside, given the widespread negativity towards the pound. To be fair it was very easy to be negative, the shambolic nature of our politics, the ineptitude of our political class, and the prospect that we could see a general election and the prospect of an anti-business Corbyn government were all valid reasons to be cautious.

Even so, knowing all of that, a lot would have needed to go wrong for a sterling collapse to happen and since then events have moved on a touch, and now that the parliamentary arithmetic has changed with the election of a new majority Conservative government and prime minister, we appear to have a pathway to a deal in the wake of this month’s landslide general election result.

Having seen the Labour Party confined to electoral oblivion as the UK voting public gave a unanimous thumbs down to Jeremy Corbyn and his policies, markets can now start to focus on the next stages of the Brexit process. We can now look towards to seeing the withdrawal agreement pass through parliament at the end of January, and then both the UK and EU can start to flesh out the future relationship.

Of course that comes with its own set of problems, notwithstanding the fact that the transition period ends at the end of 2020 an extremely short space of time to iron out some quite complex details. The one upside is that both parties are already aligned in terms of standards which means in theory a lot of the ground work is already in place, and in essence agreement only needs to come on areas of divergence, though that is likely to be easier said than done.

This year the pound has had a much better year, performing much better against the euro, which looks particularly vulnerable to further losses. The pound has also been the best performing G10 currency against the US dollar. It’s certainly been a year of ups and downs, however more importantly the pound has been able hold above a number of very key support levels.

Source: CMC Markets

Crucially the pound was able to hold above the key $1.2000 area on a weekly basis and also failed to move above the flash highs of 2016 between 0.9300 and 0.9350 against the euro, or 1.0750 on the other side.

This 1.2000 area remains a key pivot level, while the outlook for US interest rates has changed markedly from a  year ago, when they were more geared towards the upside, and are now more geared towards the prospect of further cuts. This change could well work in the pounds favour as it has for most of the second half of this year.

We’ve seen a nice rally from the August lows of 1.1950, and having broken above 1.3000 there is the real prospect we could see further gains, through the 1.3500 level, towards 1.4000 as we head into 2020.

On a technical basis the stars are also aligning for a stronger pound, whether as a result of a weaker euro or US dollar, it doesn’t really matter. What matters is what the charts are indicating, with respect to long term reversions to an average. For the last 30 years the pound has never moved more than 25% away from its 200 month moving average for a sustained period of time. 

Source: Bloomberg

In 2007 we saw a move above 2.05, however it was very short-lived with the financial crisis prompting a sharp move lower. The lows of the last three years at 1.1950 have seen this pattern repeated with a rebound off this key level. At the time, the 200 month average had a value of 1.6500, with a 25% move higher targeting a level above 2.06, while in 2016 we saw a move briefly below 1.2000, before a sharp rebound back to 1.4350, before another test of 1.2000, and another subsequent rebound. Both moves lower came in at a round a 25% move away from the 200 month MA before rebounding.

If we work in the basis that prices eventually revert to their longer term mean, only one of two things can happen, either the price moves back to the long term average, or the average comes down to meet the price, which would take longer and suggest an extended period or sideways price action. Given past price behaviour the odds favour a move in the price, towards the average.

We can also look at the daily charts for further clues in GBPUSD where we have the 50 day MA looking to move above the 200 day MA, a golden cross reversal signal which could also signal further sterling gains. This interpretation of the price action suggests that there is limited elasticity for a move much below 1.2000 in the medium term, making it more likely that we’ll see a move towards 1.4000, and even the 1.5000 area in the next two to three years.

Ultimately the direction of the pound will to some extent, depend on the ability of our politicians to coalesce around a common position and see it through. For now that still looks a tall order, and on the basis of recent behaviour I wouldn’t trust many of them to run a whelk stall, let alone arrive at a position to avert a political, as well as economic crisis.

That doesn’t mean that we shouldn’t look at probabilities when it comes to price action. Analysts should always look at how prices are behaving on a longer term time frame. When looked through this prism, the price action is telling me that the riskier side of the trade for investors is a move higher, not lower.


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