Wednesday, October 14, 2020

EU leaders signal willingness for a hard Brexit; will Johnson extend his deadline?

Tags
  • Dollar
  • Pound
  • Bank of England

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Analysts’ Pick: EU leaders signal willingness for a hard Brexit, will Johnson extend his deadline?

  • GBP/USD fell sharply during the day on signals that EU leaders are ready for a no-deal Brexit
  • Volatility is likely to ensure these couple of days, but we view Boris Johnson to be more likely to extend his self-imposed deadline on reason that there is enough progress in negotiations
  • Short-term downside is expected however, as is a rebound in GBP/USD if Johnson extends the October 15th deadline
  • Medium-to-long-term outlook remains relatively unchanged for the sterling, as economic headwinds are likely to negatively impact the currency

The main driver for sterling in the short-term will be on Brexit negotiations between the EU and UK. At the point of this writing (Wednesday afternoon, 1pm GMT +8), sterling slipped sharply after Bloomberg reported that it had seen draft conclusions for a summit with EU leaders on Thursday and Friday this week that signalled that the bloc was ready for a no-deal Brexit, with the statement "progress on the key issues of interest to the Union is still not sufficient for an agreement to be reached". With discussions intensifying over today and tomorrow, more volatility was already expected ahead of British Prime Minister Boris Johnson's self-imposed deadline tomorrow (October 15th). Investors should however note that the deadline set by Boris Johnson isn't a hard deadline, and that it is possible for discussions to continue even after the deadline up until when the transition period ends at the end of December 2020. This does mean that while downside appears to be likely as signalled by EU leaders warning each other for a no-deal event, short-term upside is also likely due to most incentives aligning both parties to come up with some form of a deal. The worst-case scenario in our view has shifted slightly towards a total abandonment of Brexit negotiations by both parties this week, which we do view as unfavourable in comparison to Johnson extending his self-imposed deadline by noting that enough progress has been made.

Medium-term risks still skew sterling to the downside however, with the daily number of Covid-19 cases accelerating and looming headwinds the British labour market faces. This rings especially true with the UK seeing a spike in Covid-19 cases in the past week, as the pace of Covid-19 cases reverses into an exponential trend. The downside risk becomes even more apparent with the UK's new Tier system that is expected to be signed into law soon after passing through the House of Commons earlier yesterday, which aims to avoid a full-on circuit breaker in the UK to stop all activity. Most cities are currently at the Tier 1 level (limit of six if meeting indoors or outdoors; pubs and restaurants to close at 10pm), with some parts of England in Tier 2 (No household mixing indoors in addition to Tier 1) With growing cases in the Northern region of England it looks increasingly likely that more cities will be put on the Tier 3 (pubs and bars not serving meals to close; no household mixing indoors or outdoors in hospitality venues; rule of six applies in outdoor public spaces; guidance against travelling in and out of the area; and option for additional measures agreed locally) alert, along with Liverpool and Knowsley. This will likely exasperate the economic situation in the UK even more and add to the pressure on the labour market.

Daily Covid-19 cases in the UK continues to accelerate, forcing the UK to renew lockdown restrictions

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Since our last coverage of the GBP/USD currency pair when Chancellor of the Exchequer Rishi Sunak had just announced the British government's new Jobs Support Scheme in September, new additions were made to the scheme, likely in support of the new Tier system. At the end of last week, Sunak unveiled additional subsidies to help businesses in the UK. The main bulk being that the government will now pay two-thirds of the wages of workers in companies that are forced to closed as a result of the restrictions in relation to Covid-19. The companies will then only need to pay for a payroll tax to cover the National Insurance as well as pension contributions for employees that are out of their jobs. This heavy subsidy is likely to benefit the hospitality industry the most, which will likely help to alleviate some of the impending layoffs that are to come by the end of the month when the current furlough scheme ends and as more cities are in England are expected to enter into higher alert levels of the Tier system. The resulting impact of the overall Jobs Support Scheme will likely be able to save most jobs excluding firms who remain open but are facing weak demand, such as the hospitality and leisure sector in some areas of the country. Still, a wave of layoffs should be expected in the UK, which should incentivise the need for more stimulus from the Bank of England (BoE) later this year.

The BoE’s asset purchases look set to hit its upper limit of 745 million pounds ahead of its November meeting

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Hence, in the short-term, we may see the GBP/USD weaken on towards 1.2778's level as EU leaders continue to test the UK's willingness of a hard Brexit. However, we view this downside to be limited in the short-run as Johnson, in our view, is more likely to extend his self-imposed deadline by remarking that enough progress has been made. This could potentially mean a slight rebound in sterling back towards 1.3008's level during the week. In the medium-to-long-term, we still view sterling's outlook as weak in comparison to other G10 currencies, as the BoE has a higher likelihood of easing than not. In addition, the British economy faces several headwinds moving forward (resulting from the immediate impact of exiting the EU bloc coupled with a weakening labour market), which is likely to amplify the pressure on its economy further. This may ultimately put enough pressure on GBP/USD back towards 1.2506's level in the medium-to-long-term. However, we note upside risks to be expected weakness in the dollar that may impact the potential downside for the currency pair as it looks increasingly likely that the greenback will continue to dip post-elections with greater uncertainty and expectations for more eventual fiscal aid in the US.

Technical Analysis:

GBP/USD

GBP/USD fell sharply earlier today on signals that the EU was ready for the UK to leave exit the bloc without a trade deal. Bearish signals in MACD started to form, while RSI indicates that it may have been due for a downside correction. The RSI chart suggests that the GBP/USD may have additional room to fall, which may be possible in the short-term as volatility continues to dominate the currency thanks to the self-imposed October 15th deadline that Johnson set. However, this would also mean a short-term rebound back towards the 1.3008's level may be seen as well, as there appears to be strong support levels at 1.2778 and 1.2712. This coincides with our fundamental analysis in which there may be some upside for sterling since Johnson may be more inclined to remark that there has been enough progress being made in Brexit negotiations to extend his deadline.

Support: 1.2778 / 1.2660 / 1.2506

Resistance: 1.3008 / 1.3069 / 1.3176

GBP/USD Chart (H4)

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