Thursday, July 30, 2020

The euro’s outperformance against major currencies highlights a potential opportunity for a correction in sterling

Tags
  • Euro
  • Pound

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Analysts’ Pick: The euro’s outperformance against major currencies highlights a potential opportunity for a correction in sterling

  • The gap between the euro and sterling’s performance against the dollar have widened over the past few weeks, suggesting that a correction in favour of the sterling may be due
  • The euro may be impact by France, as it looks especially positioned to see a spike in Covid-19 cases in the short-term
  • The UK looks set to experience an economic rebound in the short-term, but will likely suffer in the medium-to-long-term as a result of a possible sharp decline in inflation and thanks to the repercussions of Brexit.

EUR/GBP has trended much higher away from the 200-day moving average since the middle of May. While this may suggest that the cross-currency pair is in a bullish trend, it also implies that there is a large amount of optimism in the market for the EU compared to the UK. But in the short-term there may be room for the euro to depreciate against the sterling since it looks more likely that the pound is positioned to benefit from an accelerated economic recovery while the EU has a a higher likelihood to see another spike in Covid-19 cases.

EUR/GBP has fallen into a downtrend and looks set for a correction in the short-to-medium-term

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Most recently, EU leaders has managed to agree on a 750-billion-euro stimulus package for the Eurozone. With the agreement out of the way, investors will now likely be focused on a potential resurgence of Covid-19 cases in the EU, as well as post-Brexit trade negotiations. The former rings especially true, since multiple other countries that has been effective in containing the early spread of the virus has started to experience a second wave of infections. We already see Spain reporting a spike in Covid-19 cases. But France's situation looks more worrying as it starts to ramp up its testing. Average daily tests for France are only at 17 for every 100,000 people with an average daily positive rate of 20.37%, a large contrast from Italy, which is currently experiencing a average daily rate of 2.16% with an average daily testing rate of 50 per 100,000 people. While a lower average rate of testing does little to imply a larger-than-expected size of domestic infections (since there are countries with low testing rates that have managed to control the size of the epidemic), this indicator coupled with a high rate of positives signals that the French government may not be testing enough to mitigate the likelihood of the country experiencing another spike in Covid-19 cases.

A low rate of testing coupled with a high number of positives suggests that France is in a position to potentially see a sharp spike in Covid-19 cases as it ramps up testing

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In contrast, the UK has seemingly managed to contain the spread of the virus domestically, with the five-day average of new Covid-19 cases hovering between 600 to 800 over the past couple of weeks. The challenge for the UK however, will be on how the British government and the Bank of England (BoE) help to promote an economic recovery, as well as the impending exit from the EU. The challenge for the UK will as a result be more due to an impending surge in unemployment when the furlough scheme ceases in October, downward pressure on the UK's inflation rate due to the tax cuts and stimulus measures for the tourism and hospitality industry (including restaurants) as well as the Brexit measures itself. This also means that it is more likely that we will see the BoE expand its quantitative easing program at one of its meetings later this year as well, likely during the November meeting. Bloomberg's high frequency dashboard for the UK signals this, and we may start to see a faster pace of recovery in Q3, as lockdown restrictions eases more and restaurant bookings start to rebound.

High frequency data signals that the UK is starting to experience the initial phase of an economic recovery, a sharp rebound before easing into a gradual one

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As a result, the shorter-term outlook for the UK looks more promising when compared to the EU. While the EU should benefit more in the medium-to-longer-term. Currency wise, the euro has also benefitted more from the dip in demand for the dollar as investors recognise the difference in effectiveness between the EU and US' efforts in containing the virus so far. Brexit negotiations and other fundamentals are also suspected to have been discounted over the past two weeks with the dollar declining and investors flocking towards the euro in hopes to diversify away from what is likely to be a devaluation in the dollar amid strong stimulus measures and a slower economic recovery in the US. This would imply that the euro has room to fall against sterling in the short-term. The spread in performance between the euro and sterling against the dollar supports this as well, as it may be due for a regression back to the mean especially if the EU experiences another surge in Covid-19 cases.

A spread analysis between the appreciation of the euro against the dollar and sterling against the dollar suggests that it may be due for sterling to cover some ground against the euro

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Hence, the euro-pound currency cross pair may have some room to fall, possibly breaking past 0.9021's level towards 0.9002 over the medium-term since the euro may still benefit from the extended decline in the dollar. In the medium-to-long-term however, we do see the euro strengthening back higher against sterling as businesses in the UK is more likely to suffer from Brexit when compared to the EU, due to the amount of logistics needed at customs in order to continue to trade with EU members. In the case of Brexit, smaller companies are more likely to suffer from additional costs since the cost of compliance may outweigh tariff costs while bigger companies are more likely to suffer from reduced competitiveness and possibly shift out of the EU due to the additional cost to trade in the EU.

Technical Analysis:

EUR/GBP

The EUR/GBP cross pair has entered into a downtrend according to MACD with the bears looking to make a move past the 38.2% Fibonacci retracement level again. This time, they maybe able to break past that level and push the currency pair to trade within the 0.9002 and 0.9021 band. Fundamentals looks likely to help the bears as well as the bulls may lose steam even since the euro looks to be trading in an extended overbought region against the dollar. A spike in Covid-19 cases in the EU maybe the catalyst the bears need but we expect the euro to have some downside potential even without a potential spike since the UK is geared up towards an economic recovery in the short-term.

Support: 0.9048 / 0.9021 / 0.9002

Resistance:  0.9084 / 0.9137 / 0.9161

EUR/GBP Chart (H4)

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