Is the pound’s rally premature enthusiasm? – Special Report

Christina Parthenidou, XM Investment Research Desk

The British pound registered sizeable gains in July, soaring by 6.4% against the US dollar as the world was facing its first spike in infection cases since re-opening plans took effect across the globe. Its sudden impressive performance made markets wonder whether they should adopt a sell-the-rally approach or a buy-the-dip mentality in the year ahead. This report suggests that the currency could gain fresh ground in the short-term, though Brexit jitters could challenge the market in the fourth quarter.

Covid-19 restrictions could turn into the new normal

The idea of reopening economies and avoiding a second wave of infections is not realistic as the UK Prime Minister said last week. However, another lockdown is not an option either as the global economy is facing its worst recession since the Great Depression in the 1930s and such a choice could leave permanent scars and result in a prolonged crisis with mounting debt levels. Hence, a delay in reopening plans and the enforcement of mask and distance mandates seems to be the mid-solution and the UK is not an exception. Although the UK eased restrictions with some delay compared to the rest of the world, it must follow the crowd now and postpone further reopening plans to keep virus spikes under control as Boris Johnson ordered last week. Under its virus containment plans, the government also left the case of a London lockdown open despite some opposition.

Looking ahead in the year, additional infection waves and tighter restrictions could be the new normal worldwide in the absence of an effective vaccine. Hence, the pound may not react to the virus headlines in the coming months unless hospitals surpass their capacity, forcing the government to resume a full lockdown. Alternatively, in the best scenario, drug trials may surprisingly beat Covid-19, bringing the much-needed vaccine breakthrough.

Additional stimulus may provide support

In the meantime, what could feed the rally is additional stimulus and further data improvement that would indicate that financial aid is indeed working through the economy.

Unlike the US’s indecisive budget discussions, the British chancellor Rishi Sunak outlined a new package of £30bln in his summer statement last month, taking the Treasury’s total cost of support to £189bln from March. However, the package is calibrated to support the economy and not protect it. From August 1 government grants under the job retention scheme, which covers up to 80% of people’s wages, will be tapered and businesses that have furloughed staff would have to start paying national insurance and pension contributions until the program ends in October. Although the new program provides a retention bonus of £1,000 per worker to companies that bring employees out of the furlough scheme from October onwards and slashes VAT taxes in the tourism industry to 5% for six months, the Bank of England is concerned that the unemployment rate could surge as the scheme unwinds this month.

That brings us to the central bank’s policy meeting on Thursday where policymakers are expected to update their outlook on the economy. Following the £100bln increase in government bond-buying in June which raised the total asset purchases to £745bln, the new Chief Andrew Bailey is highly anticipated to keep interest rates stable at a record low of 0.1% and QE unchanged. Therefore, all the attention will be on the Quarterly Monetary Policy Report and markets will be eagerly waiting to see if there will be any downside revision in GDP growth and inflation forecasts because of the increasing virus cases.

Retail sales have been on the rise since May and business sectors returned to growth in July, with the services PMI reaching the highest level in five years. Still, a second wave of infections, restriction measures, and scared consumers could transform the V-shaped recovery to a tick-shaped and it would be interesting to see if policymakers have the same view. The decision to cut weekly asset purchases from £13.5bln to £4.5bln indicated some tightening and reflected optimism that the economy is performing better than expected. Yet, a letter sent by the BoE chief warned banks last month that negative rates are “one of the potential tools under active review”, suggesting that downside risks remain well intact.

Inflation will be closely watched over the next months for that reason. Although price growth is well below the BoE’s 2.0% target, the core Consumer Price Index (CPI) showed some signs of strength in July and remained above the EU and US equivalents. If it maintains this advantage, the need for negative rates may relatively diminish in the UK.

Brexit trade talks could keep bears in play

Nevertheless, some concerning catalyst is required for rates to drop below zero. Brexit could be one of them, so the Bank should save some stimulus as an insurance in case trade talks between the UK and the EU collapse before the transition period ends in December. Perhaps, no side would like another headache at the start of the next year and negotiations could eventually lead to a common ground. However, whether the deal could be an ideal or a premature one remains to be seen. For now, expectations are for Boris Johnson to keep pressuring the EU, having the backing of his inner cycle, until the last minute. Probably markets could get a clearer picture on what has been achieved before the EU’s October deadline, but until then the pound may be sensitive to data releases and react only to important Brexit news if any.

Also, the recent positive correlation between the euro and the pound hints that as long as the UK is treated as a European member, any positive economic developments in the union could generate positive spillovers in the British economy and therefore to its currency and vice versa. A persisting weakness in the dollar might have similar effects, especially if the virus resurgence brings more economic damage to the US than in Europe and Trump’s popularity deteriorates ahead of November’s election.

Technical levels to watch

Overall, UK fundamentals are expected to keep improving on the back of stimulus and hence add some footing under the pound unless the second wave of infections surpasses April’s peaks, pushing the country to a broader lockdown, or Brexit trade talks move in the wrong direction in autumn.

From a technical perspective, the short-term picture is also encouraging, particualarly versus the dollar. GBP/USD  refused to drop back into the ascending channel after breaking it, rebounding towards the 1.3100 area. A close above the 1.3200 level could bring new buyers into the market, sending the price up to the 1.3330 resistance region. Additional gains beyond that point may see a retest of the 2019 peak of 1.3513.

In the negative scenario, if the pair dives below 1.2970 and into the channel, it should hold above the previous high of 1.2812 in order to keep its upward pattern valid.