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Pound Sterling Recovers from Lows as EU and UK Continue to Negotiate

Merkel and Tusk

Above: File image of a previous European Council meeting. Image © European Union

- Sterling to maintain soft bias short-term

- Downside protection provided by ongoing desire by EU and UK to negotiate

- Johnson and Varadkar to meet this week in attempt to find common ground

- "considerable downside risks for Sterling remain" say Commerzbank

While the British Pound has recovered from its recent lows in early mid-week trade it remains vulnerable, with markets maintaining the view that negotiations aimed at reaching a revised Brexit deal between the EU and UK are on the verge of collapse.

The Pound fell sharply Tuesday after it was reported a Number 10 source believes there was now no chance of a Brexit deal being struck now, or ever. Yet, despite the media frenzy stoked by the comments, the two sides are still at the negotiating table.

As such, we believe that while Sterling maintains a soft tone there remains the prospect of an 11th hour deal being reached. Hope is a powerful thing and we expect the market will trade in a choppy sideways fashion as long as the two sides are seen to be engaging.

It is simply too risk for traders to bet the house on a deeper Sterling decline when there remains a chance that what we are seeing is hot air amidst intense negotiations. A deal being struck would prove to be supportive of Sterling, and were a deal passed by the House of Commons then a substantial recovery could be on offer.

Our view is that if the two sides are still engaged heading into the October 17 EU Council summit then a chance of a deal has risen considerably.

Following an acrimonious day for EU and UK relations, Ireland's Minister for Foreign Affairs Simon Coveney met with chief EU negotiator Michel Barnier and following the meeting maintained the "EU remains focused on finding solutions with the UK to avoid a 'No Deal' Brexit. Gaps remain but a deal is still possible."

The Pound-to-Euro exchange rate is today quoted at 1.11138, but had been as low as 1.1109 during the course of the past 24 hours. We expect the soft tone to be maintained, but graphs suggest Sterling is still well above levels consistent with heightened 'no deal' expectations:

Sterling to Euro exchange rate

Above: The daily chart of GBP/EUR suggests the Pound's recent weakness is relatively contained

The Pound-to-Dollar exchange rate is quoted at 1.221, but had been as low as 1.2195 over the course of the past 24 hours. The pair appears to be locked within the confines of an established range:

Pound to Dollar

Above: The daily chart for GBP/USD suggests Sterling is in the middle of a medium-term range.

We believe it is still too early to call the death of the current round of Brexit negotiations, and while we expect Sterling to remain volatile, the currency should ultimately remain contained until such a time as negotiations are either officially ended or succeed.

"Clearly some market participants had not given up hope until the last moment that the British government and the EU would be able to agree on an exit agreement before the EU summit in just under two weeks’ time," says Thu Lan Nguyen, an analyst with Commerzbank. "Sterling eased significantly, but not as significantly as to assume that the majority of market participants now expect a no-deal Brexit to happen. EUR/GBP is still trading at too large a distance to this year’s highs for that to be the case."

Prime Minister Boris Johnson spoke with Ireland's Taoiseach Leo Varadkar last night to discuss the state of negotiations, both confirmed a desire to make progress and strike a deal.

Johnson has agreed to travel to Dublin on either Thursday or Friday to further engage Varadkar on proposals for a customs border on the island of Ireland, as well as his proposal that the Stormont assembly in Northern Ireland get an ultimate say on the future relationship of Northern Ireland and the EU.

Make no mistake, the task facing Johnson is daunting.

The Prime Minister on Tuesday appealed to German Chancellor Angela Merkel to help him "get the boat off the rocks", however she declined. Downing Street sources claimed that Merkel’s response was a "clarifying moment" which suggested that a deal was "essentially impossible, not just now but ever".

Furthermore, it was claimed Merkel was reported to have said that the Britain can Brexit under current proposals, but Northern Ireland would have to remain within the EU's Customs Union.

"If proven correct, these comments point towards a rejection of Johnson’s plans of a customs zone, only to propose an unthinkable plan to split Northern Ireland away from mainland trade deals and standards. The big question is whether this is the official stance of the EU, with confirmation essentially pointing towards a likely no-deal Brexit. It looks likely that the electorate will have to decide between a conservative-led no-deal Brexit and a Corbyn-led second referendum; neither of which the markets would take particularly well to," says Joshua Mahony, an analyst with IG.

"A residual risk for a disorderly Brexit and thus considerable downside risks for Sterling remain," says Commerzbank's Nguyen.

The news of the Merkel-Johnson phone call helped send Sterling lower on the day, however it pared some of those losses amidst signs that negotiations were still ongoing despite the drama.

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Signs of Engagement

The UK and EU's technical teams are still engaged, and the European Commission's spokesperson confirmed Tuesday she does not recognise the tone struck by Merkel in her conversation with Johnson.

Speaking at a regular press briefing, the spokesperson said the EU position "has not changed: we are working for a deal" and added that as technical talks continue today she does not see "how the talks could have broken down".

Furthermore, this afternoon Ireland's foreign minister Simon Coveney says he is working "flat out" with EU chief negotiator Michel Barnier to secure a deal.

Michael Gove, the minister for no-deal planning, says the UK still wants to leave the European Union with a deal but the bloc must move its position as London has.

"We hope that the EU will engage with us seriously, and in getting out these proposals we've moved, and it is now time for the EU to move too," he told parliament.

"If it does, then there is still every chance we can leave with a new deal. However, if the EU does not move, this government is prepared to leave without a deal on the 31st."

Talks are ongoing, and if you believe the EU negotiates to the wire, then there remains a chance the two sides agree a deal.

We maintain that if the UK and EU are still negotiating by the time next week's European Council summit comes around then a deal can be possible.

We would therefore expect Sterling downside to be protected as traders will be wary of the recovery potential in the currency until such a time as talks are declared officially dead.

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