FX Focus: Brexit soap opera takes new twist

Foreign exchange analyst Rajan Dhall runs through the big issues that will drive the major currency pairs this week.

A hectic start to the week and all the focus is on sterling (GBP) after the headline resignation of Brexit minister David Davis. 

The now ex-minister has decided to leave his post after what he has called a series of disagreements with the PM over the approach to the EU exit talks, which are slowing erring on the softer side of expectations - rather unsurprisingly in the wake of warnings from a number of influential corporates based in the UK. 

The welfare of the UK is the PM's primary concern, so it is not hard to understand her skew towards a closer alignment with the EU, though naturally this is at odds with the hard-line Brexiteers who have not been shy in putting their case forward.

That a backlash was coming is not in itself a surprise, and there are likely to be many twists and turns, both within parliament and with the EU which are likely to sway in GBP sentiment going forward.  The risk now is that the PM's outright position will be undermined, and in some of his early post resignation comments, David Davis has said he would stand for PM, in what may be viewed as a veiled threat on Theresa May's tenure of leadership.  

This puts the Bank of England (BoE) in another difficult position as it weighs up the odds on whether it is the right time to start normalising interest rates.  MPC members McCafferty and Saunders have been pretty resolute in their belief that it is, and they have been recently joined by Andy Haldane, which should see at least three votes for a hike in August, as we saw indeed we saw in June. 

The British Chambers of Commerce have come out with their own opinion this weekend, where they believe such policy action at this moment in time is "ill judged", and there is every reason to believe that if the BoE does hike next month, it will be a dovish hike at the very least.  

For sterling however, there are other factors at play - namely valuation.  We have seen considerable weakness in the last two years with the post referendum Cable lows dropping below the $1.2000 mark.  The flash crash had a large part to play and, once the dust settled, we found longer term buyers were happy to re-engage long positions above here. 

The 1.2500-1.2600 area has since been deemed enough of a Brexit discount in the meantime, so should volatility produce a move below the 1.3000 mark, battle lines have been set.  

The crosses will be tougher to negotiate as GBP's key counterparts have their own weaknesses, though the euro (EUR) rate is finding some resilience around the €1.1500 mark against the dollar (USD) as more source stories reveal the latest European Central Bank (ECB) forward guidance is not shared by all. 

Certain governing council members feel H2 2019 is too late to normalise rates, and this could revive the view that the rate path cycle divergence with the US could narrow - albeit at a painfully gradual pace.  The EUR/GBP range keeps shifting, with 0.8700 still seen as a key limit on the downside, but we may have to allow for a little more on the upside, perhaps until 0.9000, though 0.8900-20 is a strong technical area.

Looking at the data run this week, UK industrial production and construction output on Tuesday is all we get, but next week sees a line-up of the employment report, inflation and consumer spending which will be far more influential on pricing for the August BoE meeting.  

Plenty of BoE speakers through the week, including governor Carney as well as Broadbent and Cunliffe.

Past performance is not a guide to future performance 

In Europe, the stand out event is the release of the ECB minutes on Thursday.  As we have already mentioned, there are reservations on the timing of when the governing council should start to normalise, and this divisive composition is enough to stem the tide of EUR weakness with the political upheaval having calmed a little.  

For EUR/USD, this could spell a stronger correction after a number of failed attempts on 1.1500 as we have highlighted above, and a push through 1.1850 could see a spike above 1.2000 before speculators start to focus on the economic divergence between the US and Europe and the rest of the major economies.  

EU and German ZEW surveys will make for interesting reading on Tuesday, with German trade out first thing Monday to show May exports and imports better than expected.  Naturally, trade could improve a little more now that the exchange rate has moved in favour of exporters; something German names have been pointing to in surveys in recent months. 

Past performance is not a guide to future performance 

In the US, as much as trade policy is in focus, it seems to have done little damage to confidence in the US economy and the prospects going forward.  However, as we saw with the non-farm payrolls report on Friday, activity and expansion is not immune to hiccups, and with earnings growth coming off the boil a little - and this may well be temporary - it is and has been cause to rein in some of the rampant USD buying.

US inflation later in the week will, therefore, be viewed with reference to household income and the impact on consumption ahead.  That said, higher inflation will likely prompt the market to firm up short end pricing again and this is largely what has driven the USD higher - despite fears of what a flattening yield curve suggests further down the line.  

On the USD index, 95.50 is clearly a line in the sand based on the data at hand.  Time frames have been dismissed out of hand as few see past the benefits of holding dollars in the current climate, with its safe haven status also having been supportive. 

This is now being challenged by a revival in gold and, having tested under $1,240, we are pushing higher again at the expense of the greenback.   The dollar index (DXY) now looks set to challenge the band of support seen in the 93.50-00 area, and a breakthrough here could see us gravitating back towards 91.00, but this could take weeks to materialise and will be data dependent - naturally.  

Past performance is not a guide to future performance