Thursday, May 21, 2020

Is Brexit still a priority for the UK?

Tags
  • Euro
  • Pound
  • European Central Bank
  • Bank of England

05212020a_ta

Analysts’ Pick: Is Brexit still a priority for the UK?

  • Economic data is unlikely to be the key driver for currencies at the moment
  • Our outlook for the euro remains better compared sterling in the short-term as EU countries starts to ease restrictions while the UK seeks a Brexit agreement
  • Brexit with a hard deadline at the end of the year is likely to strain the UK’s economy further even in the best-case scenario thanks to the Covid-19 pandemic

Markit flash PMI report for May the UK will be released today, along with the Eurozone's as well. Economists expect some improvement in PMI readings this month as some factories start to reopen. This should be the case in both the UK's and the EU's PMI numbers since March and April should have been the peak of contraction across all sectors. While economic data at this point has not been a strong driver for financial markets, continued weakness in key economic indicators signal that we will most likely see the Bank of England to increase its asset purchase program at its next meeting in June, possibly by 100bn pounds.

Inflation sank below 1% while unemployment soared in the UK in April

05212020b_ta

In addition, BoE Governor Andrew Bailey's recent comments regarding the possibility of negative interest rates in the UK may provide more downside for sterling. Bailey told lawmakers on Wednesday that the central bank is keeping tools under active review in the current situation when asked about negative interest rates. However, traders has yet to fully price in the possibility of negative interest rate in the UK, implying that there may be more room for sterling to fall as a result. It does seem that the market is rational in this situation, since negative interest rates have mostly had mixed effects on stimulating a weakening economy. Furthermore, negative rates amid the pandemic a weaker pound will likely only cause cost of imports to rise while exports remain low due to a global economic slowdown.

Overnight Index Swaps signal that sterling may have more room to fall as negative rates has not been fully priced into the market yet

05212020c_ta

The weakening situation in the UK will also weigh on the British economy on the Brexit front. With high rates of unemployment and low inflation in the country amid the Covid-19 pandemic, Brexit plans will most likely not be the priority for businesses. This means that the infrastructure as well as skilled workers that post-Brexit Britain requires may not be met by the end of the year. If the British government continues with their original plan for a hard-deadline at the end of the year for the Brexit negotiations, it looks likely that the best possible scenario (a free-trade agreement with the EU, similar to that of one between the EU and Canada) will still put excessive strain on the British economy. This is due to its existing infrastructure and talent pool, which will not be able to handle an influx of paperwork and processes that will be new for trade between the two blocs. Britain's tax authority estimates an additional 200 million customs declarations will have to be filed annually to maintain normal level of UK-EU trade. This should skew the UK's economic outlook further into the downside as a result.

Bloomberg’s Brexit barometer/Bliss Index dived amid the Covid-19 pandemic

05212020d_ta

While the EU has its own issues to deal with, the upside for the euro looks much more attractive. Germany and France's joint proposal for a European recovery fund of 500bn euros will likely help take some pressure off the ECB in regards to sovereign debt in the bloc. The proposed financial aid program will probably also help relieve some of the more affected areas in the EU. While 500bn may not be sufficient to fully pull the EU out of a crisis despite being approximately 3.6% of EU's GDP, it is still a large sum and is likely to help to somewhat ease the political discussion in the bloc for a longer-term solution to help support the members' economies amid the Covid-19 pandemic.

Countries across the EU starting to ease lockdown measure is also likely to help the euro recover faster as well as compared to sterling. Italy's Prime Minister Giuseppe Conte signing a decree on May 16th to allow foreign tourism to resume from June 3rd is an example of this in addition to multiple countries starting to reopen restaurants and retail shops this week.

New Covid-19 cases has slowed in the EU since mid-April while cases in the UK only started to slow in early-May

05212020e_ta

As a result, we see the euro's outlook stronger compared to the British pound in the short-to-medium term as the EU's economy starts to recover slightly as its economy reopens. EUR/GBP looks like to rise as a result, possibly breaking 0.9022's level to trade closer towards the 38.2% Fibonacci retracement level of 0.9036. Major risks to euro’s upside include an escalation in disagreements between EU members on the financial aid program, as well as an increase in new Covid-19 cases as countries start to ease lockdown restrictions. For sterling, positive developments regarding Brexit negotiations is likely to cause the currency to spike.

Technical Analysis:

EUR/GBP

RSI signals that the euro is close to being overbought. But as the indicator also implies that the EUR/GBP is on an uptrend momentum, there may be more upside with some small downward pressure along the way in the short-term as fundamentals support a stronger euro against sterling. Bulls are likely to continue to charge forward, especially as fundamentals support a strong euro with countries in the EU bloc starting to reopen as Covid-19 cases slow down. Strong upward momentum is also suggested if EUR/GBP manages to break the 0.9022 resistance, implying that EUR/GBP might be able to trade above the 38.2% Fibonacci level since short positions at that point could be liquidated, giving another boost to EUR/GBP prices.

Support: 0.8965 / 0.8934 / 0.8913

Resistance: 0.0922 / 0.9062 / 0.9088

EUR/GBP Chart (H4)

05212020f_ta