Sterling suffers from Brexit blues, and why European election could be bad news for the euro

The pound fell by the largest amount in a year versus the US dollar last week, as the breakdown in cross party talks at Westminster alongside expectations that Theresa May will resign before the summer recess allowing a Brexiteer to take the helm at 10 Downing Street, shook confidence in the UK currency. The pound remains the barometer for investors’ expectations of how the UK will leave the EU, and right now the threat of a no deal Brexit is as big as it ever has been.  

At the start of this new trading week, GBP/USD has tentatively picked up from Friday’s lows at 1.2715, however, gains have been slim so far suggesting that the market is not convinced by Theresa May’s “new and improved” Brexit deal passing another vote in the House of Commons next month. The disarray around how the UK will leave the EU is making it difficult to see a road to recovery for the pound. Added to this, polls suggest that the Conservatives will experience a washout at this week’s European Elections, which could trigger another leadership battle and threaten the “stability” of the British government at the same time as it tries to negotiate the all-important Brexit deal with the EU. 

The pound: on a knife edge 

As political uncertainty persists, we see more weakness for sterling, especially as we lead up to the European elections. A big win for the Brexit Party would be the worst scenario for the pound, in our view, as it would cause a flare up in concern about a no-deal Brexit. In that scenario we may see GBP/USD revisit lows last reached at the start of the year, around the $1.25 mark. If Theresa May can hold onto the premiership even after a bad election result for the Tories this week, then we would expect GBP/USD to remain range bound between $1.25-1.30 throughout the summer months. However, if she resigns or is pushed out then we expect further losses to persist. The sheer scale of the drop in the pound this week should be a warning to traders: 3 years’ after the EU referendum the pound remains as sensitive to this political phenomenon as it ever was, GBP bulls need to be on their guard. 

Another blow for pound bulls 

Also worth noting, is the latest CFTC data on speculative positioning in GBP/USD. After a decline in short GBP positions between January and March (which can be bullish for GBP), this has slowed down sharply since April, which suggests that hedge funds and other large FX traders are becoming more wary of owning the pound, which is another headwind that could halt a GBP recovery in the coming months. 

The European elections and the euro 

The European elections could also have a big impact on the euro. The single currency also faltered last week, even though it managed to make gains vs. the pound, as the spread between Italian and German sovereign bond yields widened to its highest level of the year so far. Traders need to remember that the European elections are not all about Brexit, these elections may have large ramifications for the direction of Italian politics too. Italy’s bond yields crept higher last week after its right-wing deputy PM said that Italy should allow its deficit to rise above the EU’s upper limit. If the result of the European elections sees a rise in support for Italy’s right-wing representatives then Italy may be on a collision course with Brussels over its next budget, and it may also trigger another general election. 

Overall, the threat of Italy’s deficit combined with Brexit fears could keep the euro on the back foot. EUR/USD is currently 30 pips away from its lowest level of the year so far at 1.1125, a move below here could trigger a more extreme downside reaction and a break of $1.10, ahead of $1.0950 – the low from May 2017. 

May, May go away… 

No, this isn’t in reference to Theresa May, but to the month that has been particularly bad for risk. The flare up in US-China trade relations has caused risk to be taken off the table across the board. US stocks managed to claw back some losses last week, however the decline in the key US markets on Friday suggests that investors are not yet willing to buy the dip. A cautious trading environment may cause a delay to the recovery in US stocks, and an attempt to pursue 3,000 in the S&P 500 until there is a breakthrough in the US/ China trade negotiations, which may not come until the G20 meeting next month. 

US stocks, hardly a correction 

Interestingly, the decline in US stocks last week was mild in comparison to some other markets. Investors had been looking for a pullback in stocks after strong gains in the first quarter of this year. However, May’s declines are less than 3% for the S&P 500, which hardly qualifies as a correction. This suggests either another, deeper correction is on the cards over the coming months, or that US stocks may continue to rise, even with the US/ China trade tensions simmering, as long as the tensions don’t boil over. 

Watch USD/RMB for market direction 

The biggest casualty of the US/ China trade relations is the renminbi. It has fallen sharply in recent months, and USD/RMB is close to a key level, RMB 7.00, which, if broken, could trigger a major reaction across markets. As the RMB declines, it is putting upward pressure on the JPY, which may cause the Japanese authorities to step in to weaken their currency, triggering a currency war. Also, if the RMB weakens past the key RMB 7.0 level, it will make Chinese exports that much cheaper, and more attractive to US consumers. This could trigger another round of tariffs on Chinese goods from the US, which could spook risky assets elsewhere, including stocks. That is why we will be watching USD/RMB very closely in the coming week to see if the RMB continues to decline, as the ramifications could be severe. 

Economic calendar highlights

On top of the political and geopolitical angst that is impacting financial markets right now, traders also need to watch some key economic releases this week including: UK CPI and Fed minutes on Wednesday, preliminary European PMI reports for May and the German IFO on Thursday and UK retail sales on Friday. Investors remain concerned about a deteriorating global growth picture, thus, any downside surprises in the economic data this week may trigger a reaction in FX and equity markets.