British pound optimism looking stretched

BY DEB SHAW | 

  • For the second time this year, the pound is looking short-term overbought
  • This time, optimism for a Brexit breakthrough looks overdone - putting the rally at risk
  • Harsh reality is that EU and UK remain far apart on the key issue of trade

The last time the pound looked stretched was due to rate hike expectations, but this time Brexit is in the driver’s seat. According to the BBC, deals have been struck in recent days relating to the size of the divorce bill and EU citizen’s rights in the UK. Hopes are also rising for an Irish border deal following comments from Ireland’s foreign minister who suggested a deal was “doable” prior to the upcoming EU summit. As such, the currency is rallying on the belief that a broader Brexit deal (particularly relating to trade) is within reach. Until the risk of a ‘no-deal’ scenario is removed, the pound will stay subdued even with strong growth data and future rate hikes.

While a longer-term rally is in the cards, today’s optimism seems premature as a comprehensive Brexit deal remains on the horizon. Based on recent price action, our trending indicators suggest a bullish trend for the pound both in the short-term and the medium-term. Despite the current trend, the pound is starting to look overdone on a daily chart. This is visually shown below:

 

Short-term expectations running ahead of reality

12-4-2017 GBPUSD
Source: TradingView.com / MarketsNow

 

Once bitten, twice shy?

In mid-September, GBP/USD rose above 1.35 on rate hike hopes. Looking at technical indicators suggested that the pair was overbought. At the time, we argued that the pound was susceptible to a pullback due to the one-and-done nature of the rate hike, Brexit-related uncertainty and technical resistance to further strength. The exchange rate subsequently fell to around 1.3050 in October.

Last week, GBP/USD once again rose above 1.35. Similar to the previous occurrence, the pair again breached overbought conditions based on the Relative Strength Index. This time, we are arguing that the likelihood of a breakthrough remains limited as the two sides remain far apart on the key issue of trade. The issues of technical resistance and limited progress from the ongoing negotiations also lurks in the background.

 

Likelihood of single market access remains remote, weighing on the pound

Throughout the Brexit negotiation process, Michael Barnier (the EU’s chief Brexit negotiator) has made it clear that the UK has a very limited chance of remaining in the single market. According to Reuters, the UK has rejected the EU’s key demands including open migration, EU budget payments and allowing the European Court of Justice (ECJ) to have jurisdiction in the UK. Norway and Switzerland, who have signed a series of bilateral agreements with the EU, have chosen to accept most of the EU’s key demands.

As such, Barnier has suggested that the UK should look at the current free trade agreement signed with Canada or South Korea for inspiration. While a free trade agreement would provide a degree of certainty for British businesses, it would fall short of the market’s elevated expectations today for a few reasons.

 

Even a free trade agreement would be disruptive to the status quo

Firstly, a free trade agreement would require at least two to three years to negotiate based on the Canadian experience. As this would extend today’s uncertainty several years into the future, the pound will remain weak under this scenario. Instead of prolonging the status quo, investors are looking for regulatory certainty before investing in the UK.  

The second issue is that the EU’s ‘free trade agreement’ with Canada (CETA) is fairly restrictive. Today, the UK enjoys mostly unrestricted access to EU goods and services markets. CETA imposes tariffs on key areas such as agricultural products while limiting access for firms that engage in cross-border services. Given the UK’s strength as a financial and professional services-based economy, a CETA-type deal would not sufficiently address today’s concerns.

Lastly, the EU’s demands seem far-fetched given its reluctance to allow the UK into the single market. Requests such payments for the EU budget, an unmanned border with Ireland, and ECJ jurisdiction over the UK are more appropriate for a member of the single market. By demanding significant concessions from the UK, the EU is elevating the risk of a ‘no-deal’ scenario.

 

The dreaded ‘uncertainty’ more likely to continue

Despite hopes for a breakthrough, our view is that the pound is due for another short-term pullback. The two sides remain far apart on trade and the current optimism for the UK remaining in the single market seems overdone. Unless Jean-Claude Juncker and his negotiating team are willing to make significant concessions, access to the single market appears out of reach.

Topics: British pound