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Trade Deal Pessimism Looks Misplaced, Leaves Sterling Looking Cheap

- Economic improvements aid GBP gains
- GBP was July's best performing currency
- New timeline shows Brexit talks to continue into October

David Frost

Above: File Image of the UK's chief trade negotiator, David Frost. Image ©, 10 Downing St.

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The British Pound was the best performing major currency during the previous week, with gains coming amidst a combination of better than expected domestic economic data, an ongoing global stock market recovery and expectations for an EU-UK trade deal to be agreed by October.

However, the new month starts amidst an atmosphere of sharp U.S. Dollar strength with the currency recovering from oversold levels against many of its peers.

One such peer is the Pound, where the GBP/USD exchange rate's 5.5% advance in July left the pair looking notably overbought and in need of a correction lower, which could be playing out at the start of August.

"With momentum stretched after an accelerating bull run, the bulls will need to react to Friday’s stalling candlestick to prevent what could be a corrective move developing on GBP/USD," says Richard Perry at Hantec Markets. "A candlestick that hinted at exhaustion on Friday, was arguably a shooting star, came after a succession of strong bull sessions. The RSI is historically stretched around 80 and with traders coming back in on Monday morning to see a consolidation, there is a battle for control."

The Pound's strength over recent days has nevertheless caught many analysts we follow by surprise, with many expecting the British Pound to remain a laggard and extend the multi-week bout of depreciation that had been in place in most Sterling exchange rates during the April-June period with some saying the late July gains were merely a technical month-end flow phenomenon.

However, if late July gains hold into the early part of August would dispel the view that the strength was merely due to month end flows.

"The recent economic data certainly had something to do with Sterling’s success; not only the UK numbers, all of which met or exceeded forecast, but also some of those from elsewhere which looked awful by comparison. Britain’s ecostat highlights were last Friday’s provisional purchasing managers’ indices, with the composite index at a five-year high, and mortgage approvals, which quadrupled in June," says a note from Moneycorp, a London-based foreign exchange brokerage.

GBP ends previous week on a high
Above: GBP outperformance on Friday.

The Pound-to-Euro exchange rate is currently seen trading at 1.1120 at the start of the new week while the Pound-to-Dollar exchange rate is quoted at 1.3022, having gone as high as 1.3171 on Friday.

The main domestic event for Sterling this week will be Thursday's Bank of England policy meeting, where interest rates are expected to be kept unchanged but markets will be looking for signals from Threadneedle Street as to whether quantitative easing will be expanded once more.

The key question under consideration will be whether the nascent economic outperformance has registered with the Monetary Policy Committee to the extent they sound a more upbeat tone about the outlook.

If this is to be the case, we would expect Sterling to find some support from Thursday's event as a stronger economy would potentially mean leas quantitative easing in the future, based on the rule of thumb in foreign exchange markets remains that increases to quantitative easing = a weaker currency.

"Expectations are for unchanged rates and QE, although a potential display of openness to further monetary stimulus soon should weaken the pound, especially if the negative rate option is mentioned. An expansion of QE would have a smaller impact," says Asmara Jamaleh, Economist at Intesa Sanpaolo.

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While the Bank of England will grab the foreign exchange market's attention this week, we remain of the view that the key driver for the next few months will be the outcome of EU-UK trade negotiations where we believe markets might be guilty of being too pessimistic on a pro-Sterling outcome.

"Sterling also appeared to receive support from reports that EU Brexit negotiator Michel Barnier is confident that a trade deal with Britain remains possible. It was hardly a new point of view but it reminded investors of their underlying assumption that Britain will not deliberately throw itself under the no-deal Brexit bus and the EU will not push it," says Moneycorp.

Markets remain nervous that the two sides will fail to agree a deal by the Autumn, citing the numerous briefings from both sides that talks are at a deadlock. However, we have maintained a view that this is a symptom of the two sides looking to maintain pressure and appear unwilling to back down.

Pound performance in July

Above: GBP performance in July

Compromise and a deal was only ever likely to be reached in the final moment, which is likely to be an October meeting of EU leaders.

Indeed, underpinning this view is last week's announcement setting out the timetable for further negotiating rounds which shows that the final scheduled round will end on October 02 in Brussels.

The market pessimism on the matter - that was certainly tangible during Sterling's decline in the April-June period - therefore looks somewhat misplaced, and the currency's recent outperformance might well be best explained by the view foreign exchange market participants are coming around to the view that the two sides will come to an agreement.

"Under our central scenario, we now expect the UK and the EU to arrive at a ‘bare-bones’ trade deal for goods by end-2020. The GBP is undervalued and oversold, but the weak growth outlook and Brexit uncertainty could keep it close to the lows for most of this year," says Valentin Marinov, Head of G10 FX Strategy at Crédit Agricole.