GBP Poised To Head Lower?

Sterling Trading Dynamic Has Shifted

Following Theresa May’s speech at the Conservative Party conference which suggests that that a hard Brexit was looking more likely, UK data started to print more positively. However, as the data was retrospective, GBP headed lower as markets prices for the difficult times ahead. Any post-data rally in GBP was therefore short-lived and the currency traded more like that of an emerging market with yields rising and the currency falling.

However, recently, a few key data sets have shown early signs of decline and the EM currency dynamic dissipated as the slowdown in retail sales, CPI, wages and capex began to convince the market that the long-feared Brexit slowdown was happening.

However, even with recent data weakness, Brexit is yet to materially change the data outlook. It is important though to distinguish between data that is truly linked to Brexit and simply corrections from the elevated levels that many readings had reached.  As such, it is difficult to identify this as a true Brexit-fuelled slowdown because only a few data sets are a cause for concern.

 Retail sales have slowed, but were coming down from fairly high growth rates, averaging above 5% YoY in H2 2016, which were not sustainable. PMIs have ticked lower also but with the composite reading still at 55.5, it would require a much deeper correction before pointing to a slowdown. House prices are continuing to rise for now and the slowdown in London is expected to be capped due to overseas demand linked to the weaker GBP.

Inflation & Wage Growth Key To Watch

When determining whether real rates can recover, wage growth and inflation will be the key variables to watch. These are useful indicators of second round inflationary effects and key for gauging the BOE’s likely monetary policy reaction. Presently, average weekly earnings growth is at 2.6%, up from 2% a year ago, however, it does remain below the level that would be deemed consistent with the BOE’s inflation target. So far, with most measures of inflation well anchored alongside weakness in earnings growth, it seems unlikely that the BOE will begin tightening until next year at the earliest.

Equity Valuations & Real Yields Not Positive For GBP

The fall in real yields in the UK is not a new story, however, it is important when determining whether these low levels of GBP offer a buying opportunity. Currently, the UK has the third lowest real yields and is bottom for average equity yields when compared with the rest of the G10. This is key for determining GBP’s direction over 2017 due to the likely slowdown in UK wage growth, inflation troubles and a cautious BOE.

GBP Should Outperform EUR into Eurozone Elections

Recent developments in French politics suggest that there has been a shift in how markets will trade this event risk with European yield spread widening, now fuelling EUR weakness against GBP, and also an increase in hedging flows. This requires that the likely election outcome remain around current levels, with a roughly 35% chance of a Le Pen victory. However, as seen with both the Brexit referendum and the US elections, even if this probability doesn’t change much, we could still see hedging flows driving the price action.

GBPUSD To Head Lower

GBPUSD has traded a firm 1.24 – 1.26 range over recent weeks with several tests of these limits providing no breakout. However, on the back of Trump’s speech before Congress yesterday, GBPUSD has now broken the 1.24 level as the US Dollar soars. Despite an absence of solid details regarding the administration’s fiscal policy proposals it was Trump’s signalling of his support for free trade, which assuaged concerns linked to protectionism, which spurred a bid in the Dollar.

Positioning Shows Room For Run Lower

While GBP has remained at depressed levels, positioning has seen decent covering over the last few months suggesting there is plenty of room for heavier downside engagement which could fuel the next leg lower in the pair. 

Technical Perspective

Initial support will be provided by the rising trend line from last year’s lows. A break there opens up a test of the next structural low at the 1.1990 level while beyond there the path is clear down to the GBP flash crash lows of 1.1412