Pound Wipes Out Rate-Decision Gains After ‘Tough Talk’ on Trade

(Bloomberg) --

The pound headed for the biggest slump in seven weeks as clashing statements from the U.K. and the European Union fueled fears that talks between the two sides on a future trade deal will be fraught.

Sterling fell more than 1% to lead losses among Group-of-10 currencies, wiping out last week’s advance. EU chief negotiator Michel Barnier said in Brussels that a “highly ambitious” trade deal is on offer for the U.K. -- but only if London agrees to its rules. Speaking minutes later, Prime Minister Boris Johnson rejected the demand and insisted Britain will thrive even if negotiations fail.

Pound Wipes Out Rate-Decision Gains After ‘Tough Talk’ on Trade

The pound’s drop marks a turnaround from the U.K.’s formal exit of the EU on Friday, when the currency completed its best week since mid-December after the Bank of England kept interest rates unchanged Thursday. While Britain is now in a transitional phase without rule changes, it could still be heading for an economically messy divorce if a trade agreement can’t be reached by the end of 2020.

“The tough talk from both sides has thrown quite a bit of cold water onto the post-election Boris bounce,” said Ned Rumpeltin, European head of foreign-exchange strategy at Toronto-Dominion Bank in London. “Now that Brexit is officially behind us, we think markets need to re-calibrate their expectations for a rather bumpy road ahead.”

Change in Fortunes

The pound rallied toward the end of 2019 on expectations that Johnson would win December’s election and break the U.K.’s political deadlock. The euphoria has since faded and traders are now watching for whether Britain will seek an extension to the transition period before the deadline to do so in June.

The U.K. currency fell 1.5% to $1.3015 by 3:55 p.m. in London, after gaining 1% last week. It weakened 1.1% to 84.93 pence per euro. Much of the loss came before Johnson took to the podium, suggesting traders had already positioned in advance.

“Today’s losses are probably accentuated by the fact that the pound had rallied so far after the BOE meeting,” said Jane Foley, head of foreign-exchange strategy at Rabobank in London. “That said, we suspect that cable will likely be trading below 1.30 in the weeks ahead on concerns about the tone of the talks.”

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Still, concerns over Brexit talks are just one part of the equation for pound traders.

Sterling’s slide on Monday also reflects the fact that the support it enjoyed in recent days from month-end flows is no longer there. In addition, the currency’s long-term technical charts showed bearish signals on Friday, while global markets overall are trading with a risk-off bias on concern about the economic impact of the coronavirus.

Indeed, steady options pricing suggests there is currently too much noise in the pound’s spot levels.

The challenges the U.K. and the EU face in striking a trade deal this year aren’t exactly news to traders. Nonetheless, short-term positioning remains sensitive to headlines that suggest the two sides are in for a clash -- especially after Friday’s move which came amid sizable month-end flows that pressured the dollar versus most major peers.

Add to that the chart signals that may have spurred momentum investors to chase the market lower, and sterling’s defensive start to the week may be largely explained.

The pound-dollar pair formed a bearish candle pattern on the monthly chart, the so-called hanging man, which is an early indication of a waning bullish bias. The currency has entered mean-reversion mode on the daily chart and looks to form a bearish engulfing line pattern on Monday, suggesting further downside risks. For options traders, however, this is all mostly spot noise. Front-end implied volatility is trading near recent lows, while bets for outsized moves over the next week remain subdued.

Risk reversals, which show whether traders prefer to own bullish exposure or not, remain steady. Six-month risk reversals, that cover the June deadline for extending the transition period, are near the least bearish sentiment for the pound in two years, as the market still sees a no-trade Brexit as a tail risk.

  • NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

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