( Written by Malaika Cornelio and Swastik Gupta )
The EUR/GBP pair has faced a fatiguing pair of volatility and uncertainty in lieu of the global economy’s financial crisis-ridden recent past – including today’s coronavirus-fuelled slump – but it is clear that the Brexit vote has accentuated this volatility/uncertainty duo. “Sterling volatility… is at emerging market levels and has decoupled from other advanced economy pairs for obvious reasons,” ex-BoE governor Mark Carney had saidi.
The August 2019 inflation report from the Bank of England maintained a stony-faced outlook over the 4% sterling depreciation citing the market’s increased expectations of a weaker British economy bearing the brunt of an increasingly probable no-deal Brexit. The report maintained a cautious, ‘wait-and-watch-with-bated-breath’ tone, reflecting the slight increase in risk reversal precautions that investors hurried to adoptii. Late last year, however, sterling gains were present when polls moved in the favour of a Conservative-based parliamentary majority than a hung government and the UK’s acceptance of a further Brexit extensioniii. The anticipation of these events had been positively associated with “ending the stalemate over Brexit” wherein an extended bargaining period was conflated with a higher probability of reaching a favourable deal. A similar increase in the weightage price movements place on politics has been seen in the appreciation of the euro versus the pound last year, as exemplified by the 23% decline in German car exports to the UK since the Brexit referendumiv.
Figure 1: The GBP-EUR Cross Rate over a 6-month period showing a -0.38% approximate decline in sterling versus the Euro. (https://markets.ft.com/data/currencies/tearsheet/summary?s=gbpeur)
Though green shoots of recovery emerge in Europe, the speed at which the phenomena unfold varies between the UK and the EU, as illustrated by a fall in sterling against the euro on Wednesday, characterised as “the currency’s worst percentage decline since the coronavirus market crisis in March”, which is attributed to resurfacing Brexit negotiation anxiety.
Figure 2: The BOE 2020 Monetary Policy Report signifies the core importance of Brexit in sterling pricing. ( https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2020/august/monetary-policy-report-august-2020)
Amid mounting concerns over the fragility of UK’s recovery, government debt levels clambered up precarious heights as two-year gilt yields closed at a minus-0.136% “record low” on 8 September, touching minus-0.153 the day after prior to a ‘slight rebound’v. The government’s growing debt issue may convert current economic weaknesses driven by the pandemic to having a permanent presence, coercing interest rate cuts into negative levels in the months ahead.
Nevertheless, the UK’s sanguine approach last year has purportedly carried over this year in retaliation to impeding multi-directional headwinds. This is seen from the strong policy action aiming to support boosting retail sales and reopening businesses, including the UK Treasury’s seemingly successful “eat out to help out” discount scheme, boasting purchases of 35m meals within 2 weeks of the scheme rolling outvi.
However, interruptions to BOE Chief Economist Andy Haldane’s positive economic outlook of a ‘v-shaped recovery’ are on the horizon, due to social distancing measures, and a growing year-on-year unemployment rate that is expected even under the assumption that a coronavirus vaccine will be approved in Jan 2021 and the UK agrees on a deal with the EUvii.
On the contrary, the 2021 ECB inflation projection has been revised upwards to 1%viii (Figure 2). This development has taken on a bullish turn, despite warnings of a second wave coronavirus onslaught plaguing many European nations. At yesterday’s policy event, The ECB’s highlighted leaving monetary policy unchanged as the course of action to ensure flexibility around the direction of inflationix. The Bank’s recent show of confidence in and staunch commitment to Eurozone recovery thus equated to a fall in the pound against the euro.
Figure 3: ECB Staff Macroeconomic Projections September 2020 vs June 2020 (https://www.ecb.europa.eu/pub/projections/html/ecb.projections202009_ecbstaff~0940bca288.en.html#toc8)
The UK’s recent unyielding stance in negotiations mirrors the global rise in nationalism, as it announced plans for the Internal Market Bill which abjectly disputes the EU Withdrawal Agreement that was signed in January. EU Chief Negotiator, Michel Barnier’s words, further consolidated the degree of uncertainty shrouding the GBP, as the ‘lack of trust’ and ‘significant differences’ between the negotiating parties were highlighted. Compared to the March 26 pandemic-fuelled spike in sterling implied volatility, the supervening overnight spike to 13% implicated traders’ addition of options contracts in an attempt to hedge themselves from sudden GBP movements.
To substantiate the ensuing uncertainty, a recent IG client positioning report demonstrated a strong EUR/GBP-bearish contrarian trading bias despite the roughly balanced trader standpointx.
Ultimately, the uncertainty underlying the UK’s economic outlook obstructs the possibility of an upward trajectory for the pound, especially relative to the Eurozone’s economic performance, leaving the GBP to trail behind its high-risk trading partners, particularly with the no-deal outcome of Brexit talks attributing to the market pessimism that continues dampening trading activity.
Figure 4: 1-month EUR/GBP and MACD (12, 26)
Figure 5: 1-month RSI (14) for EUR/GBP
Considering a 1-month time frame, the oscillators indicators do not suggest the strongest trade action but do suggest some action. From figure 5 you can see that the RSI (14) has been mostly stable between the upper and lower values of 70% and 30%, but in the last 5 days has cleared the upper threshold for periods, which usually indicates long-position opportunities. The 1-month value of approximately 62% is very neutral-buy I would say suggesting some lack of definitive answer to the buy Euro recommendation.
However, based on figure 4, the other main oscillator, the MACD level (12, 26) is pointing towards a clearer buy position with an approximate value between 0.007 and 0.0085. This positive value shows that the 12-period EMA (blue) has been above the 26-period EMA (orange) which indicates a bullish outlook for the Euro relative to the pound sterling. This is suggestive of a sufficiently strong buy of the Euro because the absolute MACD value is quite small. We can see this as in the last 5 days, the histograms below the baseline have got bigger suggesting a stronger trading opportunity with the buying Euros option.
The other main group of technical indicators, the moving averages all point to one market direction, up. The recent uptrend in the last week visible in figure 4 has given rise to EMA values (5-30) upwards of 0.880 and SMA values (5-30) of 0.882 through till 0.905 which are all suggestive of a strong long position of the Euro which unsurprisingly ties in with some of the fundamental analysis regarding Brexit uncertainties and tensions.
The recommendation in the short-term would be to follow the upward trend and to buy the Euro and sell GBP as the recent tension over the UK Brexit Treaty breach ensues relative to European economic recovery. Hence, there is a bearish outlook for Britain at the moment as investors fear Britain will suffer from being possibly tied in legal action with Brussels.
The long-term recommendation is heavily dependent on the outcome of Brexit whether there will be a deal or not coupled with the UK government’s ability to deal with rising coronavirus cases again which could further dampen the economy. A suggestion would be buying Euros and selling GBP if there is confirmed signs of No-Deal and further intensive lockdown measures as the economic outlook for Britain would be very negative. However, if Boris manages to calm tensions with Brussels and manages the desired deal by October 15th, alongside reducing cases without lockdown, buying GBP would be highly profitable. However, this looks unlikely and is definitely for high-risk investors.
Risk reversal – A risk reversal is a hedging strategy against a buy or sell position using put and call options by protecting investors against negative price movements whilst limiting gains.
Implied volatility –market’s prediction of a likely movement in a security’s price and is often used to price options contracts such as high implied volatility results in options with higher premiums and vice versa.
Contrarian trading – a strategy that involves going against existing market trends to generate profits i.e. buying certain securities when people are selling them vice versa
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