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Pound Sterling's Rally Clouded by Threat of Tax Hikes, Negative Brexit Headlines

- GBP outperforms USD and EUR in August
- Proposed Tax rises remind of GBP vulnerabilities
- UK could be close to walking away from Brexit trade negotiations

Fishing remains a sticking point

The EU is reportedly unwilling to discuss the issue of future fishing rights in trade negotiations. File image, picture by Andrew Parsons / No 10 Downing Street

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The British Pound rose 0.75% against the Euro and 2.32% against the U.S. Dollar in August, a rally that is viewed as unsustainable by a number of foreign exchange commentators we follow who see the threat of higher taxes in the UK and a breakdown in Brexit trade negotiations as reasons to remain cautious on the currency.

The gains come amidst an ongoing broad-based sell-off in the U.S. Dollar and an ongoing recovery in global stock markets, the background conditions which tend to aid Sterling. Also proving supportive over recent weeks was data released for the July-August period that showed the UK economic recovery was accelerating, while the Bank of England's desire to refrain from cutting interest rates to 0% or below is seen to be providing policy support.

The gains have seen the Pound-to-Dollar exchange rate start September at a fresh nine-month high at 1.3410, while the Pound-to-Euro exchange rate remains broadly supported at 1.1186; the 11-week high is at 1.1246, which was reached on Friday.

"GBP has performed well in the last few weeks, supported in part by stronger than expected data," says Robin Wilkin, Cross Asset Strategist at Lloyds Bank.

But questions of the sustainability of Sterling's rally extending over coming weeks rest on concerns that Brexit trade talks have reached an impasse and that the UK's increased spending to absorb the shock of the covid lockdown will be paid for by tax hikes that will sap the UK economy's potential growth rates in future years.

These fears were heightened when at the weekend the government leaked to the press ideas being floated by the Treasury which included raising corporation tax and raising capital gains taxes to bring them in line with traditional income taxes. Other proposals include cutting pension tax relief, an online sales tax, changes to inheritance tax and increasing fuel and other duties.

"While UK fiscal support has been critical in protecting the economy during the COVID-19 lockdown, it comes at a cost. The UK entered the pandemic with its government debt levels already more elevated than many in G10. It is a key vulnerability that leaves us unconvinced by GBP’s outperformance so far this quarter," says Daragh Maher, Head of Research, Americas/Head of FX Strategy at HSBC.

Pound in August

Above: The Pound gained against most of its G10 peers in August.

According to initial estimates by the International Monetary Fund, the UK’s covid support package will cost around £65BN, or 3.1% of national income. However, using the Office for Budget Responsibility’s Coronavirus policy monitoring database gives an estimated cost of around £120BN, or 5.9% of national income. This difference reflects that the OBR’s costing was done more recently and therefore takes into account more recent announcements.

The proposed tax hikes are expected to raise around £20BN a year but they will come as the UK leaves the EU and international businesses and investors will question the UK's attractiveness if it is raising taxes just as it is exiting the single market.

"Headlines this weekend that the UK government is pondering the need for a tax hike to address the big hole in its budget is probably weighing on Sterling," says Mathias Van der Jeugt, an analyst with KBC Markets.

Pound vs. Euro in 2020

Above: GBP/EUR in 2020. If you would like to protect your international payments budget and lock in current exchange rate levels for future use, please learn more here.

The Pound enters September amidst unsupportive Brexit news headlines, with the prospect of a 'no deal' in ongoing EU-UK trade negotiations looking to be increasingly likely according to various press reports detailing the state of play between the two sides.

The Times reports on Tuesday the EU is refusing to discuss UK proposals on a future fisheries treaty "despite it being the most difficult element in trade and security talks that have stalled".

The report suggests the EU are looking for the UK to cede ground in other areas before moving on to fisheries, which appears to be a negotiating tactic designed to secure concessions from the UK before negotiating an area where the UK holds a significant advantage given the EU is seeking access to UK waters for their fisherman from 2021 onwards.

"European diplomats and officials are increasingly pessimistic, with speculation growing that the talks will end in failure - leading to a poisoning of relations between the EU and Britain," reports the Times.

"There remains a substantial amount of ground to be covered with fishing rights and competition rules among the most contentious areas," says Jane Foley, Senior FX Strategist at Rabobank. "It is possible that the UK could be facing a scenario of a return to WTO rules on trade with Europe, which would likely increase the duration and impact of the recession. In these circumstances a negative Bank rate could not be ruled out."

Pound Dollar 2020 best

Above: GBP/USD is at a new 2020 best on Tuesday, Sept. 01. If you would like to protect your international payments budget and lock in current levels for future use, please learn more here.

The Sunday Times meanwhile reported this weekend Prime Minister Boris Johnson has instructed lead negotiator David Frost to end the negotiations if the EU does not drop demands that the UK follow EU rules concerning state aid, which is regarded by the EU as a red line.

"There has been a discussion about whether or not to compromise on state aid and Boris said no," the newspaper reported.

EU chief negotiator Michel Barnier and Frost will hold emergency talks this week in an effort to save the negotiations, according to various news reports, ahead of another formal round of negotiations starting on September 07.

The Sun meanwhile reports that Barnier has concluded talks with Frost have now gone as far as they can and only an intervention by top politicians on both sides can unblock them, a view that Pound Sterling Live expressed following the conclusion of the 7th round of negotiations two weeks ago.

"Brexit talks are, if reports are anything to go by, on the verge of a complete breakdown as the issue of sovereignty versus the single market rears its head once more. With even Michael Barnier now hoping for a deus ex machina moment from European government heads it is clear that tempers are beginning to fray and fears of a no-deal situation are on the rise," says Chris Beauchamp, Chief Market Analyst at IG.

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"There's a general feeling the political leadership in the UK is somewhat detached from the process at the moment. They think there's no reason there shouldn't be a deal and the two parties are moving in the right direction, but that's just not happening," a source told The Sun.

"Barnier is thinking 'what can I do to get the show back on the road?' and now he's asking capitals to help. He needs them to do some outreach to London to explain we're reaching the end of the road and it's the moment for political choices."

Another EU official told the newspaper: "Pretty soon either some political things have to happen or we're heading towards no deal by accident or lack of political will.”

The Pound is nevertheless taking these headlines in its stride, maintaining multi-week highs against the Euro and Dollar at the start of September. The question is whether or not the currency is defying gravity given the state of talks.

"We do not expect to see GBP strength until a deal is agreed upon," says Bipan Rai, a foreign exchange strategist at CIBC Capital Markets.