GBP/USD upside limited on hard-Brexit risks and broad based USD demand

• GBP/USD bulls back in charge, defending critical support.
• Longer-term view sees risk of a break below the psychological 1.20 handle.
• Brexit, world trade spats and COVID-19 are major risks for GBP.

GBP/USD is trading at 1.2238 and flat on the day having travelled between a low of 1.2185 and a high of 1.2249. The bulls are out on force and supporting sterling from breaking below a critical support area in the bottom half of the 1.20 handle. This is despite a broadly stronger US dollar towards the end of the week.

Trade spats in focus

One of the major drivers for the day is the spat between the US and China come back to the fore. China has warned that US measures and sanctions would result in counter-measures. The Global Times wrote

China never starts trouble and never flinches when trouble comes its way. China will firmly defend its interests if the US does things that undermine China's core interest: NPC spokesperson.

While this may have little bearing on the pound, and indirect blow for sterling bulls can be felt in the crossfire. The pound is risk-sensitive and cannot escape the bearishness subsequent to this particular theme. In fact. considering how correlated GBP is to trade negotiations between the EU and UK, whatever mess the US gets in will have some considerations for the UK more so than ever at this juncture. The UK is relying on a special deal with the US – the UK government will be hoping for some positive headlines from its trade negotiations with the US over the coming months, negotiations that have already started. 

As for Brexit, we will know in the next few weeks if Britain is to leave the European Union without a trade deal. In short, the British government’s analysis is that the disruption caused by coronavirus means that the costs of leaving without a trade deal are lower than they have ever been. A hard Brexit is back on the cards.

Last month’s news that the latest round of post-Brexit talks between the UK and the EU did not go well. Sources on both sides were reported to be sceptical as to whether an agreement could be reached by June. Since the UK government has not backed down from its commitment not to request an extension to the transition period (due to end on December 31), the risk that trade between the UK and the EU could fall back on WTO terms on the heels of a devastating recession is a tangible risk,

analysts at Rabobank explained. 

Dollar demand

This is a major weight on GBP. The US dollar is likely to remain strong in the near term for various reasons and many of which pertaining to global trade relations. While that might seem counterintuitive, as trade slows around the world and prospects of a global recession would ultimately equate to less demand for dollars, there is more to it.

Simply put, the US dollar is the world's reserve currency and no matter how much QE the Fed implements or how low rates go, the race to the bottom means that its counterpart currencies will deflate faster than the US dollar (70% dollars, 30% rest of G10 in circulation). However, there is still too much of a shortfall offshore in USD's supply vs demand (debt denominated in USD ). When you also couple this with UK gilts being issued with a negative yield as the Bank of England made clearer it is seriously contemplating being paid to borrow, mirroring Japan and Europe;s strategy, it looks one way traffic is enevitable. 

GBP/USD levels

We see scope for a dip towards GBP/USD 1.19 on a 3-month view,

– analysts at Rabobank argued